Cash Flows Discounted Using a Model-Free SDF Extracted under a Yield Curve Prior

A. Ronald Gallant, George Tauchen

Research output: Contribution to journalArticlepeer-review

Abstract

We developed a model-free Bayesian extraction procedure for the stochastic discount factor under a yield curve prior. Previous methods in the literature directly or indirectly use some particular parametric asset-pricing models such as with long-run risks or habits as the prior. Here, in contrast, we used no such model, but rather, we adopted a prior that enforces external information about the historically very low levels of U.S. short- and long-term interest rates. For clarity and simplicity, our data were annual time series. We used the extracted stochastic discount factor to determine the stripped cash flow risk premiums on a panel of industrial profits and consumption. Interestingly, the results align very closely with recent limited information (bounded rationality) models of the term structure of equity risk premiums, although nowhere did we use any theory on the discount factor other than its implied moment restrictions.

Original languageEnglish (US)
Article number100
JournalJournal of Risk and Financial Management
Volume14
Issue number3
DOIs
StatePublished - Mar 2021

All Science Journal Classification (ASJC) codes

  • Accounting
  • Business, Management and Accounting (miscellaneous)
  • Finance
  • Economics and Econometrics

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