On a Simple Econometric Approach for Utility-Based Asset Pricing Model

The Journal of Finance has published an important paper entitled A Simple Econometric Approach for Utility-Based Asset Pricing Model by Brown and Gibbon (1985). The main purpose of this paper is to extend the research of Brown and Gibbons (1985) and Karson, Cheng and Lee (1995) in estimating the relative risk aversion (RRA) parameter in utility-based asset pricing model. First, we review the distributions of RRA parameter estimate . Then, a new method to the distribution of is derived, and a Bayesian approach for the inference of is proposed. Finally, empirical results are presented by using market rate of return and riskless rate data during the period December 1925 through December 2001.     

Alternative Models for Estimating the Cost of Equity Capital for Property/Casualty Insurers

This paper estimates the cost of equity capital for Property/Casualty insurers by applying three alternative asset pricing models: the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory (APT), and a unified CAPM/APT model (Wei (1988). The in-sample forecast ability of the models is evaluated by applying the mean squared error method, the Theil U2 (1966) statistic, and the Granger and Newbold (1978) conditional efficiency evaluation. Based on forecast evaluation procedures, the APT and Wei's unified CAPM/APT models perform better than the CAPM in estimating the cost of equity capital for the PC insurers and a combined forecast may outperform the individual forecasts.     

Financial innovation, values and volatilities when markets are incomplete

The traditional pricing methodology in finance values derivative securities as redundant assets that have no impact on equilibrium prices and allocations. This paper considers a model with incomplete markets in which the valuation of derivative securities cannot be treated independently from the valuation of the primary securities. The model constitutes a framework for the analysis of the consequences of financial innovation (creation of new contracts or modification of existing contracts). We provide a numerical counterexample to the popular belief that financial innovations that increase the volatilities of traded securities are bad. In this example the introduction of an option increases the volatility of the rate of return on the underlying stock, yet the creation of this asset is unanimously supported by investors.I am grateful to H. Polemarchakis and to an anonymous referee for insightful suggestions.     

The behavior of risky asset prices in a symmetric least squares learning environment

This paper examines the dynamics of asset prices in a heterogeneous market. Traders are made up of learners who possess limited information and use limited models for predicting the future. The market also includes noise traders in the sense of Black, along with liquidity traders. Learners revise their prediction equations using least squares learning as defined by Marcet and Sargent. We derive the equilibrium price process and show how convergence is obtained. The price process is shown to have a number of interesting properties that are consistent with propositions outlined by Black. Numerical calculations for several examples illuminate how learning takes place in the model.     

The effect of early resolution of uncertainty on the valuation of assets: A dichotomy into market and non-market information

We reconsider how the temporal resolution of uncertainty about the future payoffs from capital assets affects the initial valuation of these assets. Our results regarding valuation indicate that, in an intertemporal CAPM framework, the early resolution of market uncertainty leads to an increase in the value of the market portfolio. The values of individual assets change in direct proportion to their betas. We reconcile the differing conclusions of Ross (1989) and Epstein and Turnbull (1980) regarding the early resolution of what they term idiosyncratic and asset specific information respectively.     

“Investor sentiment” and the closed-end fund puzzle: A 7 percent solution

Lee, Shleifer, and Thaler (1991) argue that the irrational noise trader model of DeLong, Shleifer, Summers, and Waldmann (1990) ... is consistent with the published evidence on closed-end fund prices. ... However, Lee, Shleifer, and Thaler provide no indication of how much of the variability of a closed-end fund's discounts and premiums is due to such investor sentiment. Using the signal extraction technique of French and Roll (1986) to measure noise, this article estimates that on average only 7 percent of the variance of a standardized measure of weekly changes in discounts and premiums can be attributed to noise-trading activity. Investor sentiment, therefore, seems to account for very little of a closed-end fund's discount and premium variability over time.     

Determinants of stock market volatility and risk premia

Summary. We show the dynamics of diverse beliefs is the primary propagation mechanism of volatility in asset markets. Hence, we treat the characteristics of the market beliefs as a primary, primitive, explanation of market volatility. We study an economy with stock and riskless bond markets and formulate a financial equilibrium model with diverse and time varying beliefs. Agents states of belief play a key role in the market, requiring an endogenous expansion of the state space. To forecast prices agents must forecast market states of belief which are beliefs of others hence our equilibrium embodies the Keynes Beauty Contest. A market state of belief is a vector which uniquely identifies the distribution of conditional probabilities of agents. Restricting beliefs to satisfy the rationality principle of Rational Belief (see Kurz, 1994, 1997) our economy replicates well the empirical record of the (i) moments of the price/dividend ratio, risky stock return, riskless interest rate and the equity premium; (ii) Sharpe ratio and the correlation between risky returns and consumption growth; (iii) predictability of stock returns and price/dividend ratio as expressed by: (I) Variance Ratio statistic for long lags, (II) autocorrelation of these variables, and (III) mean reversion of the risky returns and the predictive power of the price/dividend ratio. Also, our model explains the presence of stochastic volatility in asset prices and returns. Two properties of beliefs drive market volatility: (i) rationalizable over confidence implying belief densities with fat tails, and (ii) rationalizable asymmetry in frequencies of bull or bear states.This research was supported by a grant of the Smith Richardson Foundation to the Stanford Institute for Economic Policy Research (SIEPR). We thank Kenneth Judd for constant advice which was crucial at several points in the development of this work. We also thank Kenneth Arrow, Min Fan, Michael Magill, Carsten Nielsen, Manuel Santos, Nicholas Yannelis, Ho-Mou Wu and Woody Brock for comments on earlier drafts. The RBE model developed in this paper and the associated programs used to compute it are available to the public on Mordecai Kurzs web page at http://www.stanford.edu/ mordecai.This revised version was published online in January 2005 with corrections to the Cover date.     

The purpose of capital for institutions with government-insured deposits

An earlier version of this article was presented at a conference sponsored by Arthur Andersen, Freddie Mac, and Salomon Brothers, Capitalizing for the 90s, held in Washington DC on March 21, 1991.     

Comments on ‘The role of technological and market structure in regulatory reform’ by Ronald R. Braeutigam

These comments were prepared for 1988 Conference on Perspectives on Banking Regulation held at the Cleveland Federal Bank, November 3 and 4, 1988.     

Some Tests of the Risk-Return Relationship Using Alternative Asset Pricing Models and Observed Expected Returns

This study examines the performance of three asset pricing models: the CAPM, the APT and the UAPT using observed expected returns from a three-phase dividend discount model with Value Line analyst estimates of future company-level earnings, dividends and growth rates. Our study is the first we know of to test the three major asset pricing models using observed expected returns. Our results are similar to prior research using ex post (realized) returns in that we find that the UAPT using macroeconomic factors is the best performing model, followed by the APT and the CAPM. However, our results also suggest that the importance of macroeconomic factors is much greater to expected returns than to realized returns, and the corresponding R2 values for models using expected returns are much higher than for models using realized returns. Combining our results for the UAPT with those of Marston and Harris (1993) for the CAPM suggests that these models are more successful in tests using observed expected returns than in tests using realized returns as proxies for expected returns. Unit root tests suggest that monthly observed expected returns follow the classic random walk without drift model while monthly realized returns do not.     

Corporate Real Estate and Stock Market Performance

An interesting question in corporate real estate literature is whether real estate can improve the stock market performance of property-intensive non-real estate firms. Using a data set comprising 75 non-real estate corporations that own at least 20 percent properties, this paper empirically assesses and compares the pair-wise return, total risk, systematic risk and Jensen abnormal return performance of composite (with real estate) and hypothetical business (without real estate) firms. We employed Morgan Stanley Capital International world equity index instead of a local market index to provide some insights into the performance of the local market relative to the global market during the 1997–2001 volatile periods experienced by many Asian countries. Our results suggest the inclusion of real estate in a corporate portfolio appears to be associated with lower return, higher total risk, higher systematic risk and poorer abnormal return performance. It is therefore likely that non-real estate firms own properties for other reasons in addition to seeking improvement in their stock market performance. Further research is needed to explore the main factors contributing to corporate real estate ownership by non-real estate firms.     

Capital in banking: Past,present and future

Earlier versions of this paper were presented at a Conference on Capitalizing for the 90s in Washington, D.C., March 20, 1991, at the Western Economic Association meetings in Seattle, July 1, 1991 and at a seminar at the American Enterprise Institute on July 16, 1991.     

The origin principle and the welfare gains from indirect tax harmonization

This paper establishes a parallelism between indirect tax harmonization when taxes are levied according to the destination principle and its counterpart when taxes are imposed on an origin basis. Using a simple two-country model of international trade it is argued that, under normal circumstances, indirect tax harmonization under the origin principle, considered as a movement of domestic taxes toward an appropriately designed average tax structure, is potentially Pareto improving. It is also shown that if the initial position is a Nash equilibrium, there are exceptional situations under which the above-mentioned reform may generate an actual Pareto improvement, so that both countries improve their welfare without any need for a compensating international transfer.     

The pricing of FIREARMs (“Falling Interest Rate Adjustable-Rate Mortgages”)

The purpose of this article is to propose and price a new type of adjustable-rate mortgage: the FIREARM (Falling Interest Rate Adjustable-Rate Mortgage). The interest payments on this mortgage adjust downward whenever interest rates decline, while remaining stable when interest rates increase. The FIREARM is alternatively priced as a prepayable and non-prepayable mortgage with a spread over the short-term interest rate. We price these two instruments and contrast their prices with those of fixed-rate mortgages using the parsimonious assumptions of a non-stationary arbitrage-free binomial term structure model.     

Index Option Pricing Models with Stochastic Volatility and Stochastic Interest Rates

This paper specifies a multivariate stochasticvolatility (SV) model for the S & P500 index and spot interest rateprocesses. We first estimate the multivariate SV model via theefficient method of moments (EMM) technique based on observations ofunderlying state variables, and then investigate the respective effects of stochastic interest rates, stochastic volatility, and asymmetric S & P500 index returns on option prices. We compute option prices using both reprojected underlying historical volatilities and the implied risk premiumof stochastic volatility to gauge each model's performance through direct comparison with observed market option prices on the index. Our major empirical findings are summarized as follows. First, while allowing for stochastic volatility can reduce the pricing errors and allowing for asymmetric volatility or leverage effect does help to explain the skewness of the volatility smile, allowing for stochastic interest rates has minimal impact on option prices in our case. Second, similar to Melino and Turnbull (1990), our empirical findings strongly suggest the existence of a non-zero risk premium for stochastic volatility of asset returns. Based on the implied volatility risk premium, the SV models can largely reduce the option pricing errors, suggesting the importance of incorporating the information from the options market in pricing options. Finally, both the model diagnostics and option pricing errors in our study suggest that the Gaussian SV model is not sufficientin modeling short-term kurtosis of asset returns, an SV model withfatter-tailed noise or jump component may have better explanatory power.     

Explaining intercity home price differences

This paper develops and tests an equilibrium model seeking to explain intercity variation in owner-occupied housing prices. Empirical tests with a reduced form equation using aggregated 1980 data on 94 SMSAs suggest explanation for 84% of this intercity home price variation. Intercity housing demand, based upon homeowner quality of life equilibrium, is successfully represented by the non-monetary income determinant of climate mildness in addition to several monetary income determinants that reflect household residual after-tax real income. Intercity housing supply was found to be influenced by intercity variation in construction costs and limitations upon the available supply of undeveloped urban land.     

Why Are Earnings Kinky? An Examination of the Earnings Management Explanation

Prior research has documented a kink in the earnings distribution: too few firms report small losses, too many firms report small profits. We investigate whether boosting of discretionary accruals to report a small profit is a reasonable explanation for this kink. Overall, we are unable to confirm that boosting of discretionary accruals is the key driver of the kink. We caution the use of the ratio of small profit firms to small loss firms as a measure of earnings management. We investigate and discuss a number of alternative explanations for the kink.     

Insurance and catastrophes: The changing role of the liability system

Insurance catastrophes are increasingly the result of actions by human beings rather than nature. Chief among these insurance changes has been the surge in tort liability insurance costs. Unfortunately, the courts have misunderstood the mechanisms for transmitting these costs throughout the economy. A principal deficiency is that the structure of liability has been inconsistent with the courts' assumption that the losses could be borne by consumers or parties other than the insurer.Commentary on presentation by Richard Zeckhauser, Insurance and Catastrophes, Geneva Lecture, Paris, France, May 12, 1995.     

Commodity Taxation and Social Welfare: The Generalized Ramsey Rule

Commodity taxes have three distinct roles: (1) revenue collection, (2) interpersonal redistribution, and (3) resource allocation. The paper presents an integrated treatment of these three concerns in a second-best general equilibrium framework, which leads to the generalized Ramsey rule for optimum taxation. We show how many standard results on optimum taxation and tax reform have a straightforward counterpart in this general framework. Using this framework, we also try to clarify the notion of deadweight loss, as well as the relation between alternative distributional assumptions and the structure of optimum taxes.     

Forum Selection in International Business Contracts: Home Bias Portfolio Puzzle and Managerial Moral Hazard

We provide an economic analysis of forum selection in international business contracts. International business contracts or multi-state transactions within federally structured countries might be subject to more than one sovereign adjudication system. In case of conflict between the transacting parties, the appropriate tribunal must be identified. We examine the question of business firms' optimal choice of the forums to adjudicate future business disputes. We extend the investment model approach to litigation by applying a portfolio theory type analysis. We show that firms that prefer higher expected income and lower income volatility are better off diversifying the forums under which they litigate business disputes. This stands in contrast to real-world business practice that consistently shows a clear preference to selecting the home court and legal system to settle international business disputes. In a fraction of the cases, both parties gain by selecting a certain forum, because of specialization for example, and it becomes optimal to ignore diversification. In most cases, however, the relevant factors that affect forum selection are zero sum and priced ex ante, court bias, for example. Once priced, there is no incentive to disregard diversification. We hypothesize that, in addition to specialization, factors such as managerial moral hazard explain the real-world behavior of firms: managers are less likely to be blamed, ex post, for choosing the home court. We suggest that, as international barriers decline and international trade grows, firms will diversify the forums in which they adjudicate international business disputes.