Chapter 12 advances in consumptionbased asset pricing. The paper also extends the equilibrium characterization of interest rates of cox. Consumption is the ultimate objective of investment. I incorporate loss aversion in a consumptionbased asset pricing model with recursive preferences and solve for asset prices in closedform.
Defend the assumption that the amount of risk free bond is in zero net. How can consumptionbased assetpricing models explain. A major research initiative in finance focuses on the determinants of the crosssectional and time series properties of asset returns. Cochrane begins powerfully, introducing us to the notion that the consumption based asset pricing equation, given by an investors firstorder conditions, is the central formulation in asset pricing. Capm, icapm, apt, option pricing, and finally consumptionbased model. According to the capm, the uncertainty associated with the return on the market portfolio is the sole. Problem 1 consumption based capital asset pricing model. Basic consumptionbased asset pricing oxford scholarship.
In financial decisions and markets, john campbell, one of the fields most respected authorities, provides a broad graduatelevel overview of asset pricing. Topics in asset pricing hebrew university of jerusalem. How can consumptionbased assetpricing models explain low. Your results should be the same, since both derivations are based on the euler equation. Chapter 6 on consumption based asset pricing is likewise elegant and comprehensive. January 8, 2014 abstract we investigate the empirical performance of a simple twofactor consumption based asset pricing model for the crosssection of equity returns. A simple consumption based asset pricing model and the crosssection of equity returns robert f. The consumption capital asset pricing model ccapm is an extension of the capital asset pricing model capm that uses a consumption beta instead of a market beta to explain expected return premiums over the riskfree rate. Consumptionbased asset pricing with a reference level. John cochranes book asset pricing comes closest to the course in terms of topics. The name derives from the fact that the equations that describe the behaviour of asset prices and returns in the ccapm devolve from the consumption saving and asset choice decisions of households.
Explaining the poor performance of consumptionbased. Financial economics consumptionbased capm consumptionbased capm as equation 2 holds for any asset i, we could subtract the equation for one asset from the equation for another asset to ge t 0 e 1. A simple consumptionbased asset pricing model and the cross. A brief introduction to the consumption based asset pricing model ccapm we have seen that capm identifies the risk of any security as the covariance between the securitys rate of return and the rate of return on the market portfolio. Consumption based asset pricing 2 1 overview from macroeconomics, here are the equations that describe the aggregate production function. These topics are derivatives pricing and hedging the blackscholesmerton, the heathjarrowmorton, and the reducedform credit risk models, multiplefactor models, characterizing systematic risk, portfolio optimization, market efficiency, and equilibrium capital asset and consumption pricing models. In finance, the capital asset pricing model capm is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a welldiversified portfolio. Limitations of the capital asset pricing model capm. Here asset prices jointly satisfy the requirement that the quantities of each asset supplied and the quantities demanded must be equal at that price so called market clearing. He introduces students to leading theories of portfolio choice, their implications for asset prices, and empirical patterns of risk and return in financial markets. Each model consumption based, capm, multifactor, term structure, and option pricing is derived as a different specification of the discounted factor. Now use the consumption capital asset pricing equation previous problem to derive the equilibrium interest rate of the risk free bond. Explaining the poor performance of consumptionbased asset.
This research has propelled further interest in consumption based asset pricing, as well as some debate. Written by a major contributor to the economics of financial markets, financial decisions and markets is a comprehensive, insightful, and authoritative graduatelevel introduction to asset pricing. Simply put, the returns on small stocks and value stocks are more procyclical, explaining their high average returns. Consumptionbased asset pricing with loss aversion by. This feature of my model improves the ability to match moments on asset prices. Dynamic asset pricing theory provisional manuscript. We will now use the euler equation to derive an asset pricing equation. A consumptionbased explanation of expected stock returns.
A brief introduction to the consumption based asset. This book gives an overview of the most widely used. Pdf the consumptionbased capital asset pricing model. A brief introduction to the consumption based asset pricing. The consumption based and general equilibrium models described below are the purest examples of this approach. He and modest 1995, market frictions and consumption based asst pricing, journal of political economy 103, 94117. Most importantly, risk corrections to asset prices should be driven by the covariance of asset. Stochastic discount factor prices all assets this conceptually simple view holds. Explore the asset pricing implications of the neoclassical model 2. The discount factor framework also leads to a statespace geometry for meanvariance frontiers and asset pricing models.
The course then turns to the capital asset pricing model capm and consumption based asset pricing model, and develops dynamic portfolio choice problems and equilibrium asset pricing theories. Data from other countries are examined to see which features of the us experience apply more generally. Financial asset pricing theory offers a comprehensive overview of the classic and the current research in theoretical asset pricing. The family of consumption based asset pricing models yields a stochas tic discount factor proportional to the mar ginal rate of intertemporal substitution of consumption. New evidence from the crosssection of stock returns joachim grammig and andreas schrimpf. The asset prices we discuss would include prices of bonds and stocks, interest rates, exchange rates, and derivatives of all these underlying. Request pdf consumption based asset pricing models. Download it once and read it on your kindle device, pc, phones or tablets.
Pastor and stambaugh 2002, liquidity risk and expected stock returns, working paper, chicago and wharton. In consumptionbased assetpricing models there are no liquidity constraints or other transaction costs, so agents can trade assets freely at each period. Fundamental equation of consumptionbased asset pricing. Introduction despite their universal importance, asset pricing models are usually characterized by a puzzling contradiction. Ljunqvist and sargent, recursive macroeconomic theory for coverage of dynamic programming, as well as two excellent chapters on asset pricing. A financial model that extends the concepts of the capital asset pricing model capm to include the amount that an individual or firm wishes to. Consumption based asset pricing models use marginal rates of substitution to determine the relative prices of the date, eventcontingent, composite consumption good. Chapter 12 advances in consumption based asset pricing.
This paper provides conditions on the primitives of a continuoustime economy under which there exist equilibria obeying the consumptionbased capital asset pricing model. This book stresses the interplay between theory, econometrics, and empirics, the hallmark of john campbells research. Portfolio returns exhibit more diverse and often stronger consumption correlations, and the parameters of. Consumptionbased asset pricing models use marginal rates of substitution to determine the relative prices of the date, eventcontingent, composite consumption good. The consumption based capital asset pricing model ccapm is a model of the determination of expected i.
If the risky return covaries negatively with tomorrows consumption then the lhs is negative and the asset return bears a negative premium over the risk free rate. Consumptionbased asset pricing models academic web pages. Continuoustime asset pricing theory a martingalebased. The asset pricing model that is embedded in stochastic models of macroeconomics is called the consumption based asset pricing model ccapm. A consumptionbased explanation of expected stock returns 541 higher than the eis. A consumption based explanation of expected stock returns 541 higher than the eis.
An alternate title might be arbitrage, optimality, and equilibrium, because the book is built around the three basic constraints on asset prices. Consumptionbased model and overview princeton university. The capm model deals with the question of how asset prices and yields are determined, under the hypothesis that the riskfree interest rate and market return are variables determined outside the model. Cochrane abstract we show that the external habitformation model economy of campbell and cochrane 1999. Notes and references 175 part two dynamic models 8. If no riskfree rate, rf should be interpreted as blacks 1972 zerobeta. Asset pricing and portfolio choice theory second edition. He presents applications to stocks, bonds, and options.
John jumps right in to data with the equity premium, riskfree rate, and volatility puzzles p. From capm to market anomalies, credit risk implications for the cross section of asset returns, rational versus behavioural attributes of stylized crosssectional effects, conditional capm, conditional versus unconditional portfolio efficiency, multifactor models, interpreting factor models, machine. The paper also extends the equilibrium characterization of interest rates of. Asset pricing wikibooks, open books for an open world. Many of those works, finance journal publications and the literature on asset pricing in general, set their focus on different parts of this paper, which again underlines the. Unfortunately, consumptionbased asset pricing models prove disappoint ing empirically.
Consumption based asset pricing models the discount factor representation of asset pricing models the equity premium puzzle the risk free rate puzzle the epsteinzin preferences long run risk habit formation prospect theory 3 professor doron avramov. This model class is characterized by a stochastic discount factor process that puts restrictions on the joint process of asset returns and per capita consumption. The recent theoretical literature is used to guide the exploration of the international data. With that objective in mind, asset pricing models have been developed, starting with the capital asset pricing models of sharpe 1964, lintner 1965, and mossin 1966. A singlefactor consumptionbased asset pricing model. Optimal dynamic trading with informational advantage 7.
Theory the essential element in modern asset pricing theory is a positive random variable called the stochastic discount factor sdf. An investors firstorder conditions give the basic consumption based. Take asset j as the riskfree asset, with return d a j r d t. An overview of asset pricing models university of bath bath.
The chapter lists some important stylized facts that characterize us data, and relates them to recent developments in equilibrium asset pricing theory. Growth theory has been concerned with achieving higher per capita. For debt, asset pricing is relatively simple, as cash flows to the owner are contractually fixed. This book gives an overview of the most widely used theories in asset pricing and. In examining the empirical performance of this class of models, several puzzles are discovered. I find loss aversion increases expected returns substantially relative to the standard recursive utility model. The model is a generalization of the capital asset pricing model capm. The consumptionbased capital asset pricing model ccapm is a model of the determination of expected i. Understand the quantitative limitations of the model. The ccapm links asset pricing with macroeconomic risk. I conclude that these indices, which are approximations to the consumption of the rich, provide a useful vantage point from which we can reassess the theory of consumption based asset pricing.
Jun 22, 2019 consumption capital asset pricing model ccapm. Artem, 923 vayanos 1998, transaction costs and asset prices. Understand the pricing of insurance and aggregate risk 3. Financial decisions and markets princeton university press. Asset pricing is developed around the concept of a stateprice deflator which relates the price of any asset to its future risky dividends and thus incorporates how to adjust for both time and risk in asset valuation. Review article full text access chapter 12 tests of multifactor pricing models, volatility bounds and portfolio performance. In financial decisions and markets, john campbell provides a broad graduatelevel overview of asset pricing. On the one hand, most of the empirical factor models that can successfully explain risk premia do not provide strong guid. Themarginalutility loss of consuming a little less todayand buying a little more of the asset.
Consumption based asset pricing models use marginal rates of substitution to determine the. Consumption capital asset pricing model ccapm definition. This is the famous paper that launched the consumptionbased model and endowmenteconomy framework. Then he quickly outlines the huge literature of responses to the puzzles p. May 16, 2006 abstract this paper presents an empirical evaluation of recently proposed asset pricing models which extend the standard preference speci. Based on some approximations or an assumption of crra utility and lognormal consumption, the socalled consumption based capm or ccapm is derived and interpreted. The consumption based capital asset pricing model by darrell duffie and william zame1 the paper provides conditions on the primitives of a continuoustime economy under which there exist equilibria obeying the consumption based capital asset pricing model ccapm. This book gives an overview of the most widely used theories in asset pricing and some more.
No part of this book may be distributed, posted, or. The foundations of this concept were laid by the research of robert lucas 1978 and douglas breeden 1979. Bansal and yaron 2004, hansen, heaton, lee, and roussanov 2007, bansal, kiku, and yaron 2012, but are also supportive of a broader class of consumption based asset pricing models. The consumptionbased capital asset pricing model article pdf available in econometrica 576. Topics in asset pricing lecture notes download book. The course is selfcontained and not based on any one book. First, small stocks and value stocks have higher durable consumption betas than big stocks and growth stocks. An overview of asset pricing models andreas krause university of bath school of management phone. Inabsolute pricing, we price each asset by reference to its exposure to fundamental sources of macroeconomic risk. This book is an introduction to the theory of portfolio choice and asset pricing in multiperiodsettings under uncertainty. Consumptionbased model and overview an investor must decide how much to save and how much to consume, and what portfolio of assets to hold.
Abstract this paper examines linear asset pricing models using aggregate consumption data which are not seasonally adjusted. Introduction to asset pricing theory the theory of asset pricing is concerned with explaining and determining prices of. This book advocates a discount factor generalized method of. An overview of asset pricing models university of bath.
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