Stochastic Discount Factors and What Drives Asset Prices

Summary

The answer frames discounting as a central asset-pricing question. Under the expectation-based pricing setup described, a security’s current price is the conditional expectation of its future payoff multiplied by a stochastic discount factor. The factor’s functional form therefore determines how different future payoffs contribute to today’s price.

The response does not give a specific factor model or derive how the factor changes with issuer identity or payment structure, such as fixed versus floating cash flows. Instead, it recasts the question as identifying the state variables that drive the discount factor, represented abstractly as Z. Its point is that this is a broad, difficult research problem, not a simple rule based only on an issuer or cash-flow label. The explanation is conceptual and provides no empirical evidence or instrument-specific valuation guidance.

Key ideas

• Asset prices can be represented as conditional expectations of discounted future payoffs.
• The stochastic discount factor weights future payoffs and its functional form is central to pricing.
• The answer characterizes the drivers of that factor as state variables rather than specifying them.
• The post does not supply a model for how issuer identity or fixed versus floating payments affect discounting.

Tags

# Discounting factor depends on


# Discounting factor depends on












Does discounting factor only depends on issuer, or it also depends on structure of payments ( i.e. fixed or float)? Thank you in advance.

## Answer by fni (score 1)

https://quant.stackexchange.com/a/16588

The central theme of Asset Pricing is in detecting what drives the evolution of the (stochastic) discount factor. Academic finance assume as a methodological starting point that expectations are rational, i.e. unbiased, hence when prices ( $p_t$ ) are determined as the expected value of the discounted (by the discount factor $M_{t+1}$) payoff of the security ( $X_{t+1}$ ), i.e. $p_t = E_t [M_{t+1}X_{t+1}]$, then what really drives prices is the functional form of the (stochastic) discount factor, i.e. $M_{t+1}= f(t, Z)$ .

You are asking what $Z$ is, but if I knew it exactly I could write a paper and win the Nobel Prize!

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