Smart SDFs

63 Pages Posted: 29 Oct 2019

See all articles by Sofonias A. Korsaye

Sofonias A. Korsaye

University of Geneva - Geneva Finance Research Institute (GFRI); Swiss Finance Institute

Alberto Quaini

University of Geneva - Geneva Finance Research Institute (GFRI)

Fabio Trojani

Swiss Finance Institute; University of Geneva

Date Written: May 31, 2019

Abstract

We introduce model-free Smart Stochastic Discount Factors (S-SDFs) minimizing various notions of SDF variability under general convex constraints on pricing errors, which can be motivated by particular market frictions, asymptotic APT-type no-arbitrage assumptions or a need for regularization in large arbitrage-free asset markets. S-SDFs give rise to new nonparametric SDF bounds for testing asset pricing models, under more general assumptions on a model's ability to price cross-sections of assets. They arise from a simple transformation of the optimal payoff in a penalized dual portfolio selection problem with uniquely determined penalization function. We demonstrate the properties of S-SDFs induced by various economically motivated pricing error penalizations, which can load on a sparse set of endogenously selected securities and can produce a more robust pricing performance. We then show how pricing error and dual portfolio weight sparsity can be made compatible with tractability, i.e., smoothness, of the corresponding dual portfolio problem. For such settings, we develop the relevant methodology for the empirical analysis of S-SDFs. Lastly, we demonstrate the properties and the improved out-of-sample pricing performance of S-SDFs in various APT settings where SDF-regularization naturally matters.

Suggested Citation

Korsaye, Sofonias A. and Quaini, Alberto and Trojani, Fabio, Smart SDFs (May 31, 2019). Proceedings of Paris December 2019 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: https://ssrn.com/abstract=3475451 or http://dx.doi.org/10.2139/ssrn.3475451

Sofonias A. Korsaye (Contact Author)

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

40 Boulevard du Pont d'Arve
Geneva 4, Geneva 1211
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Alberto Quaini

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

Uni Pignon
Du-Bois-Melly
Geneva, Geneva 1205
Switzerland

Fabio Trojani

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva ( email )

Geneva, Geneva
Switzerland

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