Can Asset Pricing Models Price Idiosyncratic Risk in U.K. Stock Returns?

I examine how well different linear factor models and consumption‐based asset pricing models price idiosyncratic risk in U.K. stock returns. Correctly pricing idiosyncratic risk is a significant challenge for many of the models I consider. For some consumption‐based models, there is a clear tradeoff in the performance of the models between correctly pricing systematic risk and idiosyncratic risk. Linear factor models do a better job in most cases in pricing systematic risk than consumption‐based models but the reverse is true for idiosyncratic risk.     

An Equilibrium Model of Asset Pricing and Moral Hazard

This article develops an integrated model of asset pricing andmoral hazard. It is demonstrated that the expected dollar returnof a stock is independent of managerial incentives and idiosyncraticrisk, but the equilibrium price of the stock depends on them.Thus, the expected rate of return is affected by managerialincentives and idiosyncratic risk. It is shown, however, thatmanagerial incentives and idiosyncratic risk affect the expectedrate of return through their influence on systematic risk ratherthan serve as independent risk factors. It is also shown thatthe risk aversion of the principal in the model leads to lessemphasis on relative performance evaluation than in a modelwith a risk-neutral principal.     

Quantitative Asset Pricing Implications of Endogenous Solvency Constraints

We study the asset pricing implications of an economy wheresolvency constraints are endogenously determined to deter agentsfrom defaulting while allowing as much risk sharing as possible.We solve analytically for efficient allocations and for thecorresponding asset prices, portfolio holdings, and solvencyconstraints for a simple example. Then we calibrate a more generalmodel to U.S. aggregate as well as idiosyncratic income processes.We find equity premia, risk premia for long-term bonds, andSharpe ratios of magnitudes similar to the U.S. data for lowriskaversion and a lowtime-discount factor.     

Networks in Production: Asset Pricing Implications

In this paper, I examine asset pricing in a multisector model with sectors connected through an input‐output network. Changes in the network are sources of systematic risk reflected in equilibrium asset prices. Two characteristics of the network matter for asset prices: network concentration and network sparsity. These two production‐based asset pricing factors are determined by the structure of the network and are computed from input‐output data. Consistent with the model predictions, I find return spreads of 4.6% and ?3.2% per year on sparsity and concentration beta‐sorted portfolios, respectively.     

Alternate approach to unify CAPM and APT

We utilize the joint elliptical distribution to model a multi-factor return generating process and derive an equilibrium multi-beta capital asset pricing model (CAPM) in which the market portfolio and a set of nonelliptical factors are sufficient to price all financial assets. Most important, it is shown that the market portfolio, while generally nonelliptical, can proxy all elliptical factors and hence: including elliptical factors in addition to the market portfolio in the pricing equation contribute nothing to asset pricing. While the representative investor prices the exposure of aggregate wealth to various nonelliptical systematic risk factors, individual securities are priced in accordance to their contributions to different aspects of the risk of aggregate wealth. The present model collapses to the Sharpe-Lintner CAPM when either the market investor is neutral to nonelliptical risk factors or when all risk factors follow a joint spherical distribution. When residuals cancel out of the market portfolio, the present model collapses to Conner (1984) pricing model.     

International capital asset pricing: Evidence from options

We study the risk dynamics and pricing in international economies through a joint analysis of the time-series returns and option prices on three equity indexes underlying three economies: the S&P 500 Index of the United States, the FTSE 100 Index of the United Kingdom, and the Nikkei-225 Stock Average of Japan. We develop an international capital asset pricing model, under which the return on each equity index is decomposed into two orthogonal jump-diffusion components: a global component and a country-specific component. We apply separate stochastic time changes to the two components so that stochastic volatility can come from both global and country-specific risks. For each economy, we assign separate market prices for the two return risk components and the two volatility risk components. Under this specification, we obtain tractable option pricing solutions. Model estimation reveals several interesting insights. First, global and country-specific return and volatility risks show different dynamics. Global return movements contain a larger discontinuous component, and global return volatility is more persistent than the country-specific counterparts. Second, investors charge positive prices for global return risk and negative prices for volatility risk, suggesting that investors are willing to pay positive premiums to hedge against downside global return movements and upside volatility movements. Third, the three economies contain different risk profiles and also price risks differently. Japan contains the largest idiosyncratic risk component and smallest global risk component. Investors in the Japanese market also price more heavily against future volatility increases than against future market downfalls.     

The two-fund separation theorem revisited

This paper resolves two issues regarding the traditional capital asset pricing model with one risk-free asset which seem to have been overlooked in the literature. First, it provides an elementary and complete proof of the two-fund separation theorem which accounts for the fact that asset demand may become undefined if the limiting slopes of the investor’s indifference curves are finite. Second, it shows that an additional limiting condition on investors’ risk aversions is generally necessary to guarantee existence of an equilibrium. Moreover, a generalized existence result is formulated which includes investors who in equilibrium may not invest in risky assets and a simple condition ensuring positive equilibrium asset prices is given.     

Oil Risk Exposure: The Case of the U.S. Oil and Gas Sector

We estimate oil price risk exposures of the U.S. oil and gas sector using the Fama‐French‐Carhart's four‐factor asset pricing model augmented with oil price and interest rate factors. Results show that the market, book‐to‐market, and size factors, as well as momentum characteristics of stocks and changes in oil prices are significant determinants of returns for the sector. Oil price risk exposures of U.S. oil and gas companies in the oil and gas sector are generally positive and significant. Our study also finds that oil price risk exposures vary considerably over time, and across firms and industry subsectors.     

An Equilibrium Model of Rare-Event Premia and Its Implication for Option Smirks

This article studies the asset pricing implication of impreciseknowledge about rare events. Modeling rare events as jumps inthe aggregate endowment, we explicitly solve the equilibriumasset prices in a pure-exchange economy with a representativeagent who is averse not only to risk but also to model uncertaintywith respect to rare events. The equilibrium equity premiumhas three components: the diffusive- and jump-risk premiums,both driven by risk aversion; and the "rare-event premium,"driven exclusively by uncertainty aversion. To disentangle therare-event premiums from the standard risk-based premiums, weexamine the equilibrium prices of options across moneyness or,equivalently, across varying sensitivities to rare events. Wefind that uncertainty aversion toward rare events plays an importantrole in explaining the pricing differentials among options acrossmoneyness, particularly the prevalent "smirk" patterns documentedin the index options market.     

Macroeconomic risks and characteristic-based factor models

We show that book-to-market, size, and momentum capture cross-sectional variation in exposures to a broad set of macroeconomic factors identified in the prior literature as potentially important for pricing equities. The factors considered include innovations in economic growth expectations, inflation, the aggregate survival probability, the term structure of interest rates, and the exchange rate. Factor mimicking portfolios constructed on the basis of book-to-market, size, and momentum therefore, serve as proxy composite macroeconomic risk factors. Conditional and unconditional cross-sectional asset pricing tests indicate that most of the macroeconomic factors considered are priced. The performance of an asset pricing model based on the macroeconomic factors is comparable to the performance of the Fama and French (1993) model. However, the momentum factor is found to contain incremental information for asset pricing.     

Time series momentum and macroeconomic risk

The time series momentum strategy, previously known as trend following, has been shown to deliver consistent profitability over a long time horizon in futures markets. Funds pursuing this strategy are now a component of many institutional portfolios, due to the expectation of positive returns in equity bear markets. However, the return drivers of the strategy and its performance in other economic conditions are less well understood. We find evidence that the returns to the strategy are connected to the business cycle. Returns are positive in both recessions and expansions, but profitability is higher in expansions. Decomposing asset prices into factor related and idiosyncratic components, we associate a significant portion of returns with exposure to time varying economic factors, consistent with rational asset pricing theories having a role in explaining the profitability of the strategy.     

Consistent pricing and hedging for a modified constant elasticity of variance model

Abstract

This paper considers a modification of the well known constant elasticity of variance model where it is used to model the growth optimal portfolio (GOP). It is shown that, for this application, there is no equivalent risk neutral pricing measure and therefore the classical risk neutral pricing methodology fails. However, a consistent pricing and hedging framework can be established by application of the benchmark approach.

Perfect hedging strategies can be constructed for European style contingent claims, where the underlying risky asset is the GOP. In this framework, fair prices for contingent claims are the minimal prices that permit perfect replication of the claims. Numerical examples show that these prices may differ significantly from the corresponding ‘risk neutral’ prices.     

Cash demand,liquidation costs and capital market equilibrium under uncertainty

In this paper, the portfolio and the liquidity planning problems are unified and analyzed in one model. Stochastic cash demands have a significant impact on both the composition of an individual's optimal portfolio and the pricing of capital assets in market equilibrium. The derived capital asset pricing model with cash demands and liquidation costs shows that both the market price of risk and the systematic risk of an asset are affected by the aggregate cash demands and liquidity risk. The modified model does not require that all investors hold an identical risky portfolio as implied by the Sharpe-Lintner-Mossin model. Furthermore, it provides a possible explanation for the noted discrepancies between the empirical evidence and the prediction of the traditional capital asset pricing model.     

Innovation,Growth, and Asset Prices

We examine the asset pricing implications of a production economy whose long‐term growth prospects are endogenously determined by innovation and R&D. In equilibrium, R&D endogenously drives a small, persistent component in productivity that generates long‐run uncertainty about economic growth. With recursive preferences, households fear that persistent downturns in economic growth are accompanied by low asset valuations and command high‐risk premia in asset markets. Empirically, we find substantial evidence for innovation‐driven low‐frequency movements in aggregate growth rates and asset market valuations. In short, equilibrium growth is risky.     

Asset Pricing at the Millennium

This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the trade-off between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor (SDF) that prices all assets in the economy. The behavior of the term structure of real interest rates restricts the conditional mean of the SDF, whereas patterns of risk premia restrict its conditional volatility and factor structure. Stylized facts about interest rates, aggregate stock prices, and cross-sectional patterns in stock returns have stimulated new research on optimal portfolio choice, intertemporal equilibrium models, and behavioral finance.     

Price and Volatility Transmission across Borders

Over the past forty years, financial markets throughout the world have steadily become more open to foreign investors. With open markets, asset prices are determined globally. A vast literature on portfolio choice and asset pricing has evolved to study the importance of global factors as well as local factors as determinants of portfolio choice and of expected returns on risky assets. There is growing evidence that risk premia are increasingly determined globally. An important outcome of this force of globalization is increased comovement in asset prices across markets. This survey study examines the literature on the dynamics of comovements in asset prices and volatility across markets around the world. The literature began in the 1970s in conjunction with early theoretical developments on international asset pricing models, but it blossomed in the late 1980s and early 1990s with the availability of comprehensive international stock market databases and the development of econometric methodology to model these dynamics.     

Are Judgment Errors Reflected in Market Prices and Allocations? Experimental Evidence Based on the Monty Hall Problem

The question of whether individual judgment errors survive in market equilibrium is an issue that naturally lends itself to experimental analysis. Here, the Monty Hall problem is used to detect probability judgment errors both in a cohort of individuals and in a market setting. When all subjects in a cohort made probability judgment errors, market prices also reflected the error. However, competition among two bias-free subjects was sufficient to drive prices to error-free levels. Thus, heterogeneity in behavior can be an important factor in asset pricing, and further, it may take few bias-free traders to make asset prices bias-free.     

Option pricing and hedging in different cyclical structures: a two-dimensional Markov-modulated model

The critical role of interest rate risk and associated regime-switching risk in pricing and hedging options is examined using a closed-form valuation model. Equity call options are valued under the proposed 2-dimensional Markov-modulated model in which asset prices and interest rates exhibit Markov regime-switching features. In addition, the relationship between cyclical structures and option prices are analyzed using a time-varying transition probability matrix. The proposed model can enhance the forecast transition probabilities in an out-sample period. The cycle-stylized effect of an economy exhibits different impacts on option prices and hedging strategies in a short- and a long-cycle economy. Our closed-form formula based on more realistic specifications with respect to business-cyclical structures in various financial markets is more appropriate for pricing and hedging options.     

First steps towards an equilibrium theory for Lévy financial markets

For a continuous-time financial market with a single agent, we establish equilibrium pricing formulae under the assumption that the dividends follow an exponential Lévy process. The agent is allowed to consume a lump at the terminal date; before that, only flow consumption is allowed. The agent’s utility function is assumed to be additive, defined via strictly increasing, strictly concave smooth felicity functions which are bounded below (thus, many CRRA and CARA utility functions are included). For technical reasons we require for our equilibrium existence result that only pathwise continuous trading strategies are permitted in the demand set. The resulting equilibrium asset price processes depend on the agent’s risk aversion (through the felicity functions). Even in our simple, straightforward economy, the equilibrium asset price processes will essentially only be (stochastic) exponential Lévy processes when they are already geometric Brownian motions. Our equilibrium asset pricing formulae can also be modified to obtain explicit equilibrium derivative pricing formulae.     

Heterogeneous Expectations,Restrictions on Short Sales,and Equilibrium Asset Prices

Under heterogeneous expectations, the mean–variance model of capital market equilibrium is employed to determine the effect restricting short sales has on equilibrium asset prices. Two equivalent markets differing only with respect to short sale restrictions are compared. It is shown that, in general, risky asset prices can either rise or fall due to short sale constraints. However, under a homogeneity of beliefs for the covariance matrix of future prices, short sale constraints will only increase risky asset prices.