A critique of the stochastic discount factor methodology

Article Abstract:

In this paper, we point out that the widely used stochastic discount factor (SDF) methodology ignores a full specified model for asset returns. As a result, it suffers from two potential problems when asset returns follow a linear factor model. The first problem is that the risk premium estimate from the SDF methodology is unreliable. The second problem is that the specification test under the SDF methodology has very low power in detecting misspelled models. Traditional methodologies typically incorporate a fully specified model for asset returns, and they can perform substantially better than the SDF methodology. (Reprinted by permission of the publisher.)

Asset Accounting, Discount (Finance), Stochastic processes, Assets (Accounting)

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Closed form solutions for term structure derivatives with log-normal interest rates

Article Abstract:

We derive a unified model that gives closed form solutions for caps and floors written on interest rates as well as puts and calls written on zero-coupon bonds. The crucial assumption is that simple interest rates over a fixed finite period that matches the contract, which we want to price, are log-normally distributed. Moreover, this assumption is shown to be consistent with the Heath-Jarrow-Morton model for a specific choice of volatility. (Reprinted by permission of the publisher.)

Derivatives (Financial instruments), Interest rates

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