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More About This Textbook
Overview
This textbook takes the reader from the level of microeconomics principles through to modern asset pricing theory. Yvan Lengwiler elegantly links together issues that have in the past been the territory of general economic theorists on the one hand, and financial economists on the other.
In a sequence of carefully explained steps, the reader learns how the first welfare theorem is used in asset pricing theory. The book then moves on to explore Radner economies and von NeumannMorgenstern decision theory, and this section culminates in Wilson's mutuality principle and the consumptionbased CAPM. This is then put into a dynamic setting, and term structure models are introduced. The empirical shortcomings of the standard asset pricing models are extensively discussed, as is research from the last twenty years aimed at bringing theory in line with reality. The reader is brought up to date on the latest areas of concern, such as habit formation, the consequences of heterogeneity, demographic effects, changing tax regimes, market frictions, and the implications of prospect theory for asset pricing.
Aimed at masters or Ph.D. students specializing in financial economics, the book can also be used as a supplementary text for students of macroeconomics at this advanced level and will be of interest to finance professionals with a background in economics and mathematics. It includes problems (with solutions), and an accompanying website provides supporting material for lecturers.
Editorial Reviews
From the Publisher
"Microfoundations of Financial Economics is a wonderful book. In less than 300 pages of highly readable text, Yvan Lengwiler covers the basics of modern asset pricing theory. Students of advanced finance will want to use this book as an effective learning tool and reference. It's going to be a permanent part of my library."—Simon Benninga, Tel Aviv University and , EditorinChief, European Finance Review"This book can be a great asset for Ph.D. students that are overwhelmed by asset pricing. . . . Lengwiler [has] produced a nice addition to recent publications that bridge the gap between undergraduate and advanced Ph.D. textbooks."—EconomicDynamics Newsletter
European Finance Review  Simon Benninga
Microfoundations of Financial Economics is a wonderful book. In less than 300 pages of highly readable text, Yvan Lengwiler covers the basics of modern asset pricing theory. Students of advanced finance will want to use this book as an effective learning tool and reference. It's going to be a permanent part of my library.European Finance Review
Microfoundations of Financial Economics is a wonderful book. In less than 300 pages of highly readable text, Yvan Lengwiler covers the basics of modern asset pricing theory. Students of advanced finance will want to use this book as an effective learning tool and reference. It's going to be a permanent part of my library.— Simon Benninga, Tel Aviv University and , EditorinChief
EconomicDynamics Newsletter
This book can be a great asset for Ph.D. students that are overwhelmed by asset pricing. . . . Lengwiler [has] produced a nice addition to recent publications that bridge the gap between undergraduate and advanced Ph.D. textbooks.Product Details
Related Subjects
Meet the Author
Yvan Lengwiler is Professor of Economics at the University of Basel. He has published articles on general equilibrium theory, asset pricing, and auction theory in the "American Economic Review, Economic Theory", the "Journal of Monetary Economics", and other publications.
Read an Excerpt
Microfoundations of Financial Economics
An Introduction to General Equilibrium Asset PricingBy Yvan Lengwiler
Princeton University Press
Princeton University PressAll right reserved.
ISBN: 0691126313
Chapter One
Introduction1.1 What finance theory is about
How much should you save? and How much risk should you bear? When we think about these questions, it becomes clear pretty quickly that they are of great importance to our overall material wellbeing. Saving is essential because most of us will retire at some point. From that point onwards, although we will still be consuming, we will receive no more labor income. Moreover, we will all face significant economic risks during our livesthe risk of losing our job, for instance, ormuch worseof becoming unable to work because of illness or other misfortunes. Clearly, the risks we are exposed to can have a huge effect on our future life, and it is therefore essential to make rational decisions about how much risk to bear.
Important as these questions are for each one of us, individuals' decisions about saving and risktaking also matter for society as a whole. Total saving determines the amount of investment that the economy as a whole can realize and thus affects future production possibilities. The amount of risk that people are willing to bear determines whether risky projects will be undertaken. Individual decisions in the face of futureretirement and risk and the capital requirements of more or less risky investment projects are coordinated through financial markets. If markets work well, risk is allocated to those people who are least hurt by it, impatient people get to consume before they earn (by taking out a loan), and capital is allocated to those projects that generate the most attractive riskreturn profile. Finance is concerned with the determination of those prices that equalize demand and supply on these markets and with their effect on the allocation of capital and risk across agents in the economy.
Finance theory is also useful in interpreting financial market prices in ways that are of interest for public policy and social welfare issues. Robert Lucas (1987), for instance, has examined the social costs of business cycles. This is obviously important for economic policy making, but it is also important for macroeconomic theory. To learn the answer to this question, we need to know how much people dislike risk, that is, variations in income. More specifically, in order to judge how expensive business cycles are, we need to determine a price that people would be prepared to pay to avoid the income variations caused by business cycles. Modern asset pricing theory allows usat least in principleto do just that.
1.2 Some history of thought
General equilibrium theory, macroeconomics, and asset pricing theory are three fields in economics that have converged more and more over the last thirty years or so. In this section we consider how this convergence came about.
1.2.1 General equilibrium theory
General equilibrium theory is an approach to describing the behavior of an economy as a whole by working out the optimal behavior of each member of the set of agents that make up the economy, and looking for a point of mutual compatibility or consistency. The theory assumes that individuals do not interact with each other directly. Interaction occurs only indirectly, through anonymous markets on which prices (exchange rates for different commodities) are posted. A second assumption that goes hand in hand with anonymity is that each individual is small in relation to the market, so that everyone neglects his own influence on market prices. This assumption is called perfect competition. Models that make these two assumptions are called Walrasian, in honor of Léon Walras (1874) who was the first to formulate such a model. We say that the economy is in equilibrium if, at a certain price, each individual buys or sells the optimal quantities (given his tastes and possibilities) of all commodities and the total supply of each commodity equals the total demand for it.
Modern general equilibrium theory in the tradition of Arrow & Debreu (1954) accommodates a large number of different goods and very diverse preferences of individuals. This research has established conditions that guarantee the existence of an equilibrium. It has also developed properties of equilibrium allocations, such as the welfare theorems. The two welfare theorems demonstrate that market equilibrium allocations and socially efficient allocations are equivalent, under some conditions. This equivalence will be extremely useful for our purposes.
This theory was significantly advanced by Hirshleifer (1965, 1966) and Radner (1972). These authors built financial markets into the model and thus provided the first crucial ingredient for making general equilibrium theory applicable to finance. Moreover, their work opened up the possibility of analyzing financial markets that are incomplete in the sense that the available financial instruments may not be sufficient to trade all individual risks efficiently. This incompleteness opens the door to various sorts of coordination failures in a market economy.
By the late 1950s, general equilibrium theory had become the cornerstone of microeconomics, and remained so until it was slowly pushed aside by advances in game theory and information economics in the 1970s. General equilibrium theory has, however, received a new lease of life through its applications to the theory of macroeconomic fluctuations and the theory of asset pricing.
1.2.2 Macroeconomics
When John Maynard Keynes (1936) developed his General Theory, the world was in disarray. Mass unemployment and mass bankruptcy had eruptedfirst in the U.S.A. but then quickly spreading throughout the capitalist world. Possibly because of these events, Keynes chose a style of model that broke with the tradition of classical economics. His model did not feature individual agents explicitly, nor did it feature dynamics of any sort. Instead, he focused on the interdependence between different aggregate variables. In that sense, Keynes's model is a general equilibrium model, yet one in which the aggregate demand and supply functions are not developed from an individual optimization perspective. This became most clear in Hicks's (1937) version of Keynes's model, which came to dominate macroeconomic thinking.
This lack of microfoundation led to problems associated with the endogenous determination of expectations. Clearly, expectations should affect an individual's decisions. We would expect that rational decision makers will try to collect information if faulty decisions are costly. Hicks's version of Keynes's model really lacked a convincing theory of expectations. This omission led to increasing dissatisfaction with the model on purely theoretical grounds and ultimately to a dramatic empirical failure with the stagflation of the 1970s, which was an impossible event in the KeynesHicks orthodoxy.
These developments gave impetus to a new, or rather renewed old, approach, namely to construct dynamic models of aggregate economic fluctuations based on individual decisions together with shocks of some sort (most prominently to technology). The rational expectations revolution in macroeconomics is nothing but a simplified version of Radner's (1972) idea of an "equilibrium of plans, prices, and price expectations." The early macro versions of this idea were simplified, in the sense that agents were assumed to have an unbiased expectation of the mean of stochastic variables only, whereas in Radner's model agents have correct statecontingent expectations.
In essence, this is what the New Classical and later Real Business Cycle theory consist of: computable dynamic stochastic general equilibrium models. Compared with traditional general equilibrium theory, the macroeconomic variants are typically simpler because they feature only one good and one agent, and give scant attention to the conditions for aggregation. They also make much stronger assumptions concerning preferences and technology in order to get easily computable equilibria. Modern New Keynesian theory and the New Neoclassical Synthesis models deviate from the Walrasian orthodoxy by introducing various frictions into the model. But they, too, work within the general equilibrium framework and assume representative goods and agents.
1.2.3 Finance
Finance theory started out as a field of business administration. Sensible decision making about how to finance operations is obviously vital for any firm, and the placement of free reserves into financial assets can have a substantial impact on the profitability of the enterprise. Markowitz's (1952) meanvariance mechanics was a breakthrough, offering a much more sophisticated decision rule than was common at the time, but one that was still simple to apply.
Markowitz's contribution serves as a tool for decision making; accordingly, his research is silent about the determination of asset prices. Their stochastic properties are taken as given. Subsequently, emphasis shifted away from using properties of asset prices to guide """"' decisions, towards explaining asset prices. The capital asset pricing model (CAPM) of Sharpe (1964) and others assumes that the economy is populated by Markowitzian meanvariance decision makers. With the help of some additional assumptions, Sharpe concludes that the market portfolio must be meanvariance efficient, and that every agent must hold a mixture of the riskfree asset and the market portfolio (twofund separation theorem). Most significantly, this theory implies that only that part of the risk of an asset that is correlated with the whole market carries a premium in equilibrium.
Today finance is largely concerned with the implications of no arbitrage conditions for asset prices. Absence of arbitrage opportunities is a weak form of rationality or equilibrium requirement. An arbitrage portfolio is a portfolio that guarantees positive payoffs but whose price is zero or negative. If such a portfolio exists, it is possible to generate infinite payoffs without taking any risk. An absence of arbitrage opportunities means that asset prices must be such that no arbitrage portfolio exists. This is certainly reasonable, but the no arbitrage assumption alone does not allow one to incorporate all the economic fundamentals of preferences and endowments which arguably drive the decisions about intertemporal allocation and risk exposure; nor does it fully exploit the implications of market equilibrium. Equilibrium requires more: namely that the total supply of each asset equates the total demand for it. Relating asset prices to the extensive data of the economy in this way not only makes for a more complete (and hopefully more precise) theory, but also allows for interpretations of these prices that are beyond the range of possibilities when using just the assumption of arbitrage conditions alone.
1.2.4 Macrofinance: a unified generalequilibriumassetpricingbusinesscycletheory
Traditional general equilibrium theory as well as macroeconomics focuses on the description of properties of equilibrium allocations. The scope is different, with macroeconomics concentrating on the time series (dynamical) aspects of aggregate measures of economic activity and traditional general equilibrium theory targeting questions of existence and efficiency of equilibria. But general equilibrium theory is also able to make statements about equilibrium prices. General equilibrium theory that focuses on the explanation of prices of financial assets may be called equilibrium asset pricing theory. Equilibrium asset pricing theory in this generality (heterogeneous goods and agents and general preferences) has not enough structure to yield interesting results, though, and it has proved very fruitful to impose more structure on preferences.
It was (one of) Stiglitz's (1970) contribution(s) to connect finance more closely with economic theory. By explaining the demand for financial assets with a utility maximization problem whose ultimate goal is the optimal choice of consumption, he paved the way to Lucas's (1978) tree model and Breeden's (1979) consumption capital asset pricing model (CCAPM). Here we will call this model the finance economy, because it is a general equilibrium model that is simplified and specialized in exactly the way that financial economists have found useful. This model is the result of the combination of ArrowDebreuRadner general equilibrium theory and von NeumannMorgenstern expected utility theory. The first welfare theorem of general equilibrium theory allows us to transform the general version of the model into a much simpler onegood, oneagent economy. We will discuss in detail how this aggregation can be performed. Expected utility theory gives much more structure to the behavior of people with respect to risk taking, and thus allows for a theory with more concrete predictions about equilibrium asset prices.
What exactly does the finance economy look like? First of all, there is only one agent, hence the equilibrium allocation is trivial: the single agent eats the output. Moreover, we are dealing with an exchange economy; that is to say, there is no production, so the endowment is exogenous (but still stochastic). Thus, the equilibrium allocation is also exogenous: the single agent eats his own endowment.
What's the point of this? Why should a model like this be of interest? Since quantities are not the focus of the analysis, it is natural to choose a model in which the equilibrium allocation is given beforehand. Thus, moving from the traditional general equilibrium model to the finance economy simplifies the model in exactly the way we want: we lose information on items that we do not aim to explain, such as equilibrium trades, distribution, and allocations, but we keep all the information on equilibrium prices. Such a model is perfectly geared for investigating how changes of stochastic properties of endowments affect equilibrium prices of different kinds of securities.
The field that studies these relationships could be called macrofinance, because the objective is to explain financial market data with aggregate or macroeconomic shocks. By building on a complete (if simplified) general equilibrium model, macrofinance provides microeconomic foundations for more conventional theories of finance. This microeconomic foundation helps us to gain deeper insights, because it relates asset price data to individual preferences over risk and time and aggregate consumption fluctuations, and thus allows us to interpret asset prices in terms of structural data of the economy.
1.3 The importance of the puzzles
This general model can be applied to a quite diverse set of objects. For instance, we can make predictions about the return rates of bonds of different maturities, thereby generating an equilibrium model of the term structure of interest rates. The model also makes predictions about the equilibrium return rate of riskfree bonds and of risky shares. The difference between the two is called the equity premium. Unfortunately, this application of the model fails miserably: it predicts a much higher riskfree return rate than what we observe in the data, and it predicts a very low (almost zero) equity premium, which is not at all what we typically observe in the data.
(Continues...)
Table of Contents
List of boxes xi
Preface xiii
1 Introduction 1
1.1 What Finance theory is about 1
1.2 Some history of thought 2
1.3 The importance of the puzzles 7
1.4 Outline of the book 9
2 Contingent claim economy 10
2.1 The commodity space 10
2.2 Preferences and ordinal utility 14
2.3 Maximization 16
2.4 General equilibrium 23
2.5 The representative agent 32
Notes on the literature 35
Problems 35
3 Asset economy 37
3.1 Financial assets 37
3.2 Pricing by redundancy 41
3.3 Radner economies 46
3.4 Complete markets (and uniqueness of Arrow prices) 53
3.5 Complications arising from market incompleteness 60
Notes on the literature 65
Problems 65
4 Risky decisions 68
4.1 Bernoulli's St.Petersburg paradox 69
4.2 Using more structure: probabilities and lotteries 71
4.3 The von Neumann Morgenstern representation 75
4.4 Measures of risk preference 81
4.5 Assumptions and evidence 86
4.6 Often used specifications 91
Notes on the literature 99
Problems 99
5 Staticfinance economy 102
5.1 An economy with von Neumann Morgenstern agents 102
5.2 Efficient risksharing 107
5.3 A representative NM agent 112
5.4 Who holds what kind of portfolio? 121
5.5 The stochastic discount factor 126
5.6 The equilibrium price of time 130
5.7 The equilibrium price of risk 132
5.8 Some important special cases 134
Notes on the literature 138
Problems 138
6 Dynamicfinance economy 141
6.1 A static dynamic model 141
6.2 Dynamic trading 149
6.3 Models of the real interest rate 162
6.4 Portfolio selection 168
Notes on the literature 170
Problems 170
7 Empirics and the puzzles 172
7.1 Collecting the right data 172
7.2 The equity premium puzzle 176
7.3 Alternative interpretations of the data 184
7.4 Excessive volatility 192
7.5 Anomalies 197
Notes on the literature 198
8 Adapting the theory 199
8.1 Assumptions of the mainstream model 199
8.2 Nonstandard preferences 201
8.3 Heterogeneity 214
8.4 Efficiency failure 225
Notes on the literature 238
9 Epilog 239
9.1 A mystery 240
9.2 A challenge 241
9.3 The party's over 242
Appendix A Symbols and notation 245
Appendix B Solutions to the problem sets 247
Bibliography 269
Index 285