Smart Stochastic Discount Factors

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.