Capital asset prices with heterogeneous beliefs

Assuming continuous trading in continuous time with Brownian motion processes, the basic capital asset pricing model of Sharpe, Lintner, and Mossin is developed under arbitrary distributions of investors' beliefs consistent with available information. Results on the processing of information are reported, and properties of investors' portfolios are derived.     

Prospect theory,the disposition effect,and asset prices

We build a general equilibrium model to examine the implications of prospect theory for the disposition effect, asset prices, and trading volume. Diminishing sensitivity predicts a disposition effect, price momentum, a reduced return volatility, and a positive return-volume correlation. Loss aversion generally predicts the opposite. In calibrated economies, there is a nontrivial range of preference parameters for prospect theory to simultaneously explain the disposition effect, the momentum effect, and the equity premium puzzle. Our model is helpful for understanding a wide range of financial phenomena and it also suggests new testable predictions.     

Disagreement and asset prices

How do differences of opinion affect asset prices? Do investors earn a risk premium when disagreement arises in the market? Despite their fundamental importance, these questions are among the most controversial issues in finance. In this paper, we use a novel data set that allows us to directly measure the level of disagreement among Wall Street mortgage dealers about prepayment speeds. We examine how disagreement evolves over time and study its effects on expected returns, return volatility, and trading volume in the mortgage-backed security market. We find that increased disagreement is associated with higher expected returns, higher return volatility, and larger trading volume. These results imply that there is a positive risk premium for disagreement in asset prices. We also show that volatility in and of itself does not lead to higher trading volume. Instead, only when disagreement arises in the market is higher uncertainty associated with more trading. Finally, we are able to distinguish empirically between two competing hypotheses regarding how information in markets gets incorporated into asset prices. We find that sophisticated investors appear to update their beliefs through a rational expectations mechanism when disagreement arises.     

Risk and capital asset prices

This paper is an empirical examination of the statistical significance of the residual variance of individual assets as compared with the covariance of returns with various market portfolio proxies in predicting expected return. The data and analysis we present suggest that measures of covariance are no more significant than residual variance in predicting expected return. In this sense our paper is not supportive of the Sharpe-Lintner or Black versions of the capital asset pricing model.     

On the qualitative effect of volatility and duration on prices of Asian options

We show that under the Black–Scholes assumption the price of an arithmetic average Asian call option with fixed strike increases with the level of volatility. This statement is not trivial to prove and for other models in general wrong. In fact we demonstrate that in a simple binomial model no such relationship holds. Under the Black–Scholes assumption however, we give a proof based on the maximum principle for parabolic partial differential equations. Furthermore we show that an increase in the length of duration over which the average is sampled also increases the price of an arithmetic average Asian call option, if the discounting effect is taken out. To show this, we use the result on volatility and the fact that a reparametrization in time corresponds to a change in volatility in the Black–Scholes model. Both results are extremely important for the risk management and risk assessment of portfolios that include Asian options.     

Time-varying risk aversion and asset prices

This paper uses a variant of the consumption-based representative agent model in Campbell and Cochrane [Campbell, J.Y., Cochrane, J.H., 1999. By force of habit: Consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205–251] to study how investors’ time-varying risk aversion affects asset prices. First, we show that a countercyclical variation of risk aversion drives a procyclical conditional risk premium. Second, we show that with a small value for the volatility of the log surplus consumption ratio, a large value of risk aversion may not determine whether the equity premium and the risk-free rate puzzles can be resolved or not. Third, we show that countercyclical risk aversion may not help explain the predictability of long-horizon stock returns, the univariate mean-reversion of stock prices and the “leverage effect” in return volatility.     

Default risk premium and asset prices

We estimate a standard structural model of credit risk to draw insights about the premium demanded by investors for bearing default risk, using data on credit default swaps and market capitalization. We pin down the daily market value of assets for a set of non-financial firms and uncover cross-sectional heterogeneity in terms of the magnitude and time variation of the premium. By exploring the link between asset and default risk premia, we show that this heterogeneity closely depends on the relationship between the firm-specific market value of the assets and the business cycle.     

Margin requirements and equilibrium asset prices

This paper studies the effect of margin requirements on asset prices and trading volume in a general equilibrium asset pricing model where Epstein-Zin investors differ in their degree of risk aversion. Under the assumptions of unit intertemporal elasticity of substitution and zero net supply of riskless assets, I show analytically that binding margin requirements do not affect stock prices. This result stands in contrast to previous partial equilibrium analysis where fixed margin requirements increase the volatility of stock prices. In this framework, binding margin requirements induce a fall in the riskless rate, increase its volatility, and increase stock trading volume.     

Consumption growth predictability and asset prices

We derive and test a consumption-based intertemporal asset pricing model in which an asset earns a risk premium if it performs poorly when expected future consumption growth deteriorates. The predictability of consumption growth combined with the recursive preference delivers news about future consumption growth an additional risk factor, in addition to news about current consumption growth. We model the consumption growth dynamics using a vector autoregressive (VAR) structure with a set of instrumental variables commonly used for forecasting future economic growth. Our VAR estimation provides strong empirical support for future consumption growth predictability. The cross-sectional test shows that the model explains reasonably well the dispersion in average excess returns of 25 portfolios sorted on size and book-to-market, as well as 25 portfolios sorted on size and long-term return reversal. Growth stocks and long-term winners underperform value stocks and long-term losers, respectively, because growth stocks and long-term winners hedge adverse changes in the future consumption growth opportunities.     

Hidden persistent disasters and asset prices

This study analyzes the effects of agents’ learning about hidden persistent economic disasters on asset prices. In this study, it is assumed that aggregate consumption follows a hidden Markov regime-switching process and a representative agent infers the current regime, normal regime, or disaster regime, sequentially from the realized path of the past consumption process. In this setting, the fluctuation in the agent’s posterior probabilities of the disaster regime augments the volatility of equity returns. By utilizing the stochastic differential utility, this study demonstrates that the current model can help resolve many asset pricing puzzles including the equity premium puzzle, equity volatility puzzle, and risk-free rate puzzle simultaneously. Further, the current model predicts the counter-cyclical pattern in the equity premium and equity-return volatility on the normal regime, although asset returns are negative and highly volatile during disasters. The study also demonstrates that, if the agent’s preferences are restricted to time-additive power utility, the consideration of hidden persistent disasters deepens the asset pricing puzzles.     

Exchange rate regimes and asset prices

We study the implications of alternative exchange rate regimes for asset prices in a portfolio balance model motivated by the recent US-China experience. We establish that asset price responses to various shocks differ across a flexible regime and a -unilateral- peg but the differences for most shocks tend to be rather small. Moreover, while both monetary and public debt expansions have inflationary effects on equity prices, the latter's impact is stronger under a flexible exchange rate regime. These two findings suggest that a flexible USD/rimni rate would not have limited the recent asset price inflation in the US.     

Intergenerational risksharing and equilibrium asset prices

In the presence of overlapping generations, a social security system, with contingent taxes and benefits, can affect both asset prices and intergenerational risksharing. In a simple model with two risky factors of production—human capital, owned by the young, and physical capital, owned by all older generations—a social security system that optimally shares risks exposes future generations to a share of the risk in physical capital. Such a system reduces precautionary saving and increases the riskbearing capacity of the economy. Under plausible conditions it increases the riskless interest rate, and lowers the price and risk premium of physical capital.     

Returns to scale and asset prices

The q‐theory of investment is proposed to explain firm growth effects, where previous papers identify a negative effect of firm growth, including asset growth, real investment and net share issuance, on future stock returns. This paper uses returns to scale from the production function to test the dynamic q‐theory, which predicts that the firm growth effect is theoretically weaker for firms with decreasing returns to scale (DRS) than for non‐DRS firms. Our empirical results generally support the prediction of dynamic q‐theory. However, we find that the dynamic q‐theory explains little of the value, momentum and ROE effects from the standpoint of returns to scale.     

Global asset prices and FOMC announcements

This paper analyzes the impact of U.S. monetary policy announcement surprises on foreign equity indexes, short- and long-term interest rates, and exchange rates in 49 countries. We use two proxies for monetary policy surprises: the surprise change to the current target federal funds rate (target surprise) and the revision to the expected path of future monetary policy (path surprise). We find that different asset classes respond to different components of the monetary policy surprises. Global equity indexes respond mainly to the target surprise; exchange rates and long-term interest rates respond mainly to the path surprise; and short-term interest rates respond to both surprises. On average, a hypothetical surprise 25-basis-point cut in the federal funds target rate is associated with about a 1 percent increase in foreign equity indexes and a 5 basis point decline in foreign short-term interest rates. A surprise 25-basis-point downward revision in the expected path of future policy is associated with about a ½ percent decline in the exchange value of the dollar against foreign currencies and 5 and 8 basis point declines in short- and long-term interest rates, respectively. We also find that asset prices’ responses to FOMC announcements vary greatly across countries, and that these cross-country variations in the response are related to a country’s exchange rate regime. Equity indexes and interest rates in countries with a less flexible exchange rate regime respond more to U.S. monetary policy surprises. In addition, the cross-country variation in the equity market response is strongly related to the percentage of each country’s equity market capitalization owned by U.S. investors. This result suggests that investors’ asset holdings may play a role in transmitting monetary policy surprises across countries.     

Modeling the behavior of real asset prices

Recently there has been much research treating housing and other real assets as financial claims, primarily in order to value their derivative assets, such as mortgages and mortgage-backed securities. Real asset prices are then typically modeled as a lognormal process, in the same manner that has traditionally been applied to firm value. The service flow or implicit value of a house is thus considered, in analogy with stock dividends, to be a fixed proportion of the fluctuating house price. We consider the appropriateness of this formulation and draw some distinctions between real assets, such as a house, and investment enterprises, such as a firm. We then propose an alternative method of formulating the service flow and the price of real assets which seems more appropriate to the economic characteristic of such assets.     

Fundamentals and bubbles in asset prices: Evidence from U.S. and Japanese asset prices

This paper investigates the existence and extent of non-fundamental bubbles in both U.S. and Japanese asset prices by employing a flexible empirical method which allows us to decompose asset prices into fundamental and non-fundamental bubble components. This study finds that a substantial fraction of U.S. and Japanese asset prices is accounted for by non-fundamental bubble components and that these asset prices overreact to non-fundamental bubble shocks. In addition, allowing for time-varying interest rates as another fundamental factor does not change any qualitative results about the role of non-fundamental bubble components. This suggests that the present value model fails to explain volatile asset price behavior even with time-varying interest rates. This paper was initially written when I was visiting Keio University in Japan. I benefited from several discussions with Mike Dothan, Pat Hess, and Steve LeRoy in my department, Takashi Kaneko, Yukitami Tsuji and Naoyuki Yoshino at Keio University, and Yong-Seok Park at the International University of Japan. Special thanks are due to the anonymous referee and the editor of this journal, who provided many useful and insightful comments that helped to improve the paper. This research was in part supported by a grant from the International Program Development.     

The impact of monetary policy on asset prices

Estimating the response of asset prices to changes in monetary policy is complicated by the endogeneity of policy decisions and the fact that both interest rates and asset prices react to numerous other variables. This paper develops a new estimator that is based on the heteroskedasticity that exists in high-frequency data. We show that the response of asset prices to changes in monetary policy can be identified based on the increase in the variance of policy shocks that occurs on days of FOMC meetings and of the Chairman's semi-annual monetary policy testimony to Congress. The identification approach employed requires a much weaker set of assumptions than needed under the “event-study” approach that is typically used in this context. The results indicate that an increase in short-term interest rates results in a decline in stock prices and in an upward shift in the yield curve that becomes smaller at longer maturities. The findings also suggest that the event-study estimates contain biases that make the estimated effects on stock prices appear too small and those on Treasury yields too large.     

Risk aversion and the intertemporal behavior of asset prices

In this article, we characterize economies in which both cashflows and forward prices follow random walks. We show in thecase of geometric random walks that the preferences of the representativeinvestor are of the constant proportional risk-aversion type.We also show the conditions under which spot prices follow randomwalks and under which the equivalent martingale measure is non-state-dependent.