Covariance, stochastic discount factor (SDF) and risk aversion

John Cochrane states, that if the covariance between the stochastic discount factor and the payoff is zero – then risk aversion should have no impact on the pricing. I do not fully understand why this is the case. Since in the pricing formula P = E(Mx) with M as the SDF and x as they payoff if I have a different risk aversion should that not still change the price? Or is this statement with respect that there is just no risk premium in this case even with different risk aversion?

Quantitative Finance Asked by Question Anxiety on December 29, 2020

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The Euler equation is $$p=mathbb{E}[MX]=mathbb{C}text{ov}(M,X)+mathbb{E}[M]mathbb{E}[X].$$ If the payoff $X$ doesn't covary with the stochastic discount factor (or pricing kernel), then it does not have systematic risk. Because $mathbb{E}[M]=frac{1}{R_f}$, where $R_f$ is the risk-free rate, you indeed obtain $$p=frac{mathbb{E}[X]}{R_f}.$$ As you see, you compute the (real world) expected payoff and simply discount at the risk-free rate. The agent's utility (be it time separable, recursive or whatever) and risk aversion does not enter the pricing formula.

Remember that in the CAPM only comovement with the market (as measured by market beta) is priced. Well, in the CAPM, the SDF is a linear function of the market returns. Thus, the same intuition applies here: if the payoff of your asset doesn't covary with the market ($beta=0$), then the risk-free rate is the appropriate discount rate -- regardless of potential idiosyncratic risk. Only covariance with the SDF (market) is priced.

Answered by Kevin on December 29, 2020

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