Scandinavian Working Papers in Economics
Working Papers in Economics,
University of Gothenburg, Department of Economics
No 159: Volatility of the Stochastic Discount Factor, and the Distinction between Risk-Neutral and Objective Probability Measures
Gurdip Bakshi (), Zhiwu Chen () and Erik Hjalmarsson ()
Additional contact information
Gurdip Bakshi: Smith School of Business, Postal: University of Maryland, College Park, MD 20742
Zhiwu Chen: Yale School of Management, Postal: 135 Prospect Street, New Haven, CT 06520,
Erik Hjalmarsson: Department of Economics, Postal: Yale University,28 Hillhouse, New Haven, CT 06510
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.
Keywords: Risk-neutral measures; objective probability measures; volatility of the stochastic discount factor; no-arbitrage; Hansen-Jagannathan bounds
JEL-codes: G10
23 pages, February 2, 2005
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