Smart Stochastic Discount Factors

75 Pages Posted: 8 Jul 2021 Last revised: 6 Aug 2021

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

Fabio Trojani

Swiss Finance Institute; University of Geneva

Date Written: July 1, 2021

Abstract

We propose a novel no-arbitrage framework, which exploits convex asset pricing constraints to study investors’ marginal utility of wealth or, more generally, Stochastic Discount Factors (SDFs). We establish a duality between minimum dispersion SDFs and penalized portfolio selection problems, building the foundation for characterizing the feasible tradeoffs between a SDF’s pricing accuracy and its comovement with systematic risks. Empirically, a minimum variance CAPM–SDF produces a Pareto optimal tradeoff. This SDF only depends on two distinct risk factors: A traded market factor and a minimum variance excess return that bounds the mispricing of risks unspanned by market shocks.

Keywords: SDF, Convex Pricing Constraints, Minimum Dispersion SDF, Market Frictions, SDF regularization, Arbitrage Pricing Theory

JEL Classification: G12

Suggested Citation

Korsaye, Sofonias A. and Quaini, Alberto and Trojani, Fabio, Smart Stochastic Discount Factors (July 1, 2021). Swiss Finance Institute Research Paper No. 21-51, Available at SSRN: https://ssrn.com/abstract=3878300 or http://dx.doi.org/10.2139/ssrn.3878300

Sofonias A. Korsaye

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 (Contact Author)

University of Geneva ( email )

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