Mathematical finance | Stochastic calculus

Stochastic discount factor

The concept of the stochastic discount factor (SDF) is used in financial economics and mathematical finance. The name derives from the price of an asset being computable by "discounting" the future cash flow by the stochastic factor , and then taking the expectation. This definition is of fundamental importance in asset pricing. If there are n assets with initial prices at the beginning of a period and payoffs at the end of the period (all xs are random (stochastic) variables), then SDF is any random variable satisfying The stochastic discount factor is sometimes referred to as the pricing kernel as, if the expectation is written as an integral, then can be interpreted as the kernel function in an integral transform. Other names sometimes used for the SDF are the "marginal rate of substitution" (the ratio of utility of states, when utility is separable and additive, though discounted by the risk-neutral rate), a "change of measure", "state-price deflator" or a "state-price density". (Wikipedia).

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Related pages

Marginal rate of substitution | Mathematical finance | Random variable | Hansen–Jagannathan bound | Integral transform | Financial economics | Asset pricing | Fundamental theorem of asset pricing | Utility | Covariance