Cost minimization and the stochastic discount factor

Cost minimization and the stochastic discount factor

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Article ID: iaor20103199
Volume: 176
Issue: 1
Start Page Number: 349
End Page Number: 368
Publication Date: Apr 2010
Journal: Annals of Operations Research
Authors: ,
Keywords: investment
Abstract:

It is shown that a cost function subject to internal costs of adjustment induces a stochastic discount factor (pricing kernel) that is a function of random output, input and output prices, existing capital stock, and investment. The only assumption on firm preferences is that they are increasing in current period consumption and future stochastic consumption. This ensures that the firm will always act to minimize current period cost of providing future consumption, and it is the first-order conditions for this cost minimization problem that generate the stochastic discount factor, which itself can be interpreted as the marginal variable cost of varying stochastic output. A cost-based pricing kernel is estimated using annual time-series data on macroeconomic variables and returns data for the S&P 500 and commercial paper.

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