Constrained Currency Stochastic Discount Factors

Abstract

We develop a new methodology for estimating empirical stochastic discount factors (SDFs) that balances regularizing constraints on position leverage and guidance toward minimum-entropy SDFs. These empirical SDFs exhibit superior out-of-sample pricing performance in the cross-section of currency strategies compared to existing factors. Moreover, they are priced in multiple cross-sections, such as hedge funds, that were not used in their construction. Empirical SDFs with the best pricing performance feature leverage limits consistent with institutional practices and correlate with economic fundamentals implied by equilibrium asset pricing models, such as consumption growth and uncertainty, intermediary capital, and government bond convenience yields.

Revision requested at the Journal of Financial and Quantitative Analysis