Stochastic Discount Factor (SDF) Models

Stochastic Discount Factor (SDF) models are used in finance to determine the present value of future cash flows from assets. The SDF acts as a tool that adjusts future cash flows for risk and uncertainty, allowing investors to assess how much they should pay today for those future benefits. Essentially, it factors in the likelihood of various outcomes and their potential impact, helping to explain how different assets are valued in markets. SDF models capture the idea that cash flows are less valuable if they're uncertain, guiding investment decisions based on risk preferences.