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Volatility of the Stochastic Discount Factor, and the Distinction between Risk-Neutral and Objective Probability Measures

Author

Listed:
  • Bakshi, Gurdip

    (Smith School of Business)

  • Chen, Zhiwu

    (Yale School of Management)

  • Hjalmarsson, Erik

    (Department of Economics)

Abstract

This paper derives a measure that characterizes the distance between the risk-neutral and the objective probability measures for any candidate asset pricing model. We formally show that the distance metric is equal to the volatility of the stochastic discount factor. This theoretical result gives an alternative interpretation to the Hansen-Jagannathan bounds: they provide a lower bound for the distance between the objective and the risk-neutral probability measures. Our empirical application provides support for the notion that the crash of 1987 has widened the wedge between the risk-neutral and the objective probability measures.

Suggested Citation

  • Bakshi, Gurdip & Chen, Zhiwu & Hjalmarsson, Erik, 2005. "Volatility of the Stochastic Discount Factor, and the Distinction between Risk-Neutral and Objective Probability Measures," Working Papers in Economics 159, University of Gothenburg, Department of Economics.
    • Handle: RePEc:hhs:gunwpe:0159
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    File URL: http://hdl.handle.net/2077/2766
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    References listed on IDEAS

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    Cited by:

    1. Belén Nieto & Gonzalo Rubio, 2007. "Measuring time-varying economic fears with consumption-based stochastic discount factors," Economics Working Papers 1029, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2007.

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    More about this item

    Keywords

    Risk-neutral measures; objective probability measures; volatility of the stochastic discount factor; no-arbitrage; Hansen-Jagannathan bounds;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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