September 2019. GrowthPolicy’s interviewed John Y. Campbell, Morton L. and Carole S. Olshan Professor of Economics at Harvard University, on the current investing environment, asset pricing, stock market lessons from India, and solutions for financial crises. | Read more interviews like this one.
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GrowthPolicy.org. One of your renowned contributions to the field of asset pricing theory is the . Would you tell our readers why this model is both significant and different from the various extant financial models of time-and-risk related discounting?
John Campbell: The stochastic discount factor approach is a unified framework for thinking about asset pricing. It gives economists a common language in which we can express different views of the economic forces driving asset markets. Any specific model in which there are no arbitrage opportunities—that is, no ways to get money with no risk and no initial investment—can be expressed in the language of the stochastic discount factor or “SDF.” I did not invent the SDF approach but I have used it extensively in my work. One of the things I have always emphasized is that the rewards for taking risk in asset markets seem to vary over time. As a specific example, the equity premium (the expected excess return on stocks over safe money market investments) was much higher in the recession of the early 1980s, and again during the global financial crisis in late 2008, than it was in a boom time such as the year 2000. To explain this one needs a model in which the volatility of the SDF varies over time. At each point in time and in each possible state of nature, the SDF is proportional to the marginal utility of wealth for investors—that is, the value investors place on an extra dollar. So the question becomes, why is this marginal utility more volatile in recessions than in bo