Financial Decisions and Markets: A Course in Asset Pricing

Financial Decisions and Markets: A Course in Asset Pricing

by John Y. Campbell

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Overview

Financial Decisions and Markets: A Course in Asset Pricing by John Y. Campbell

From the field's leading authority, the most authoritative and comprehensive advanced-level textbook on asset pricing

In Financial Decisions and Markets, John Campbell, one of the field’s most respected authorities, provides a broad graduate-level overview of asset pricing. He introduces students to leading theories of portfolio choice, their implications for asset prices, and empirical patterns of risk and return in financial markets. Campbell emphasizes the interplay of theory and evidence, as theorists respond to empirical puzzles by developing models with new testable implications. The book shows how models make predictions not only about asset prices but also about investors’ financial positions, and how they often draw on insights from behavioral economics.

After a careful introduction to single-period models, Campbell develops multiperiod models with time-varying discount rates, reviews the leading approaches to consumption-based asset pricing, and integrates the study of equities and fixed-income securities. He discusses models with heterogeneous agents who use financial markets to share their risks, but also may speculate against one another on the basis of different beliefs or private information. Campbell takes a broad view of the field, linking asset pricing to related areas, including financial econometrics, household finance, and macroeconomics. The textbook works in discrete time throughout, and does not require stochastic calculus. Problems are provided at the end of each chapter to challenge students to develop their understanding of the main issues in financial economics.

The most comprehensive and balanced textbook on asset pricing available, Financial Decisions and Markets is an essential resource for all graduate students and practitioners in finance and related fields.

  • Integrated treatment of asset pricing theory and empirical evidence
  • Emphasis on investors’ decisions
  • Broad view linking the field to financial econometrics, household finance, and macroeconomics
  • Topics treated in discrete time, with no requirement for stochastic calculus
  • Forthcoming solutions manual for problems available to professors

Product Details

ISBN-13: 9780691160801
Publisher: Princeton University Press
Publication date: 10/31/2017
Pages: 480
Sales rank: 649,839
Product dimensions: 7.10(w) x 10.10(h) x 1.40(d)

About the Author

John Y. Campbell is the Morton L. and Carole S. Olshan Professor of Economics at Harvard University. His books include The Econometrics of Financial Markets (Princeton) and Strategic Asset Allocation: Portfolio Choice for Long-Term Investors.

Table of Contents

Figures xiii

Tables xv

Preface xvii

Part I Static Portfolio Choice and Asset Pricing

1 Choice under Uncertainty 3

1.1 Expected Utility 3

1.1.1 Sketch of von Neumann-Morgenstern Theory 4

1.2 Risk Aversion 5

1.2.1 Jensen’s Inequality and Risk Aversion 5

1.2.2 Comparing Risk Aversion 7

1.2.3 The Arrow-Pratt Approximation 9

1.3 Tractable Utility Functions 10

1.4 Critiques of Expected Utility Theory 12

1.4.1 Allais Paradox 12

1.4.2 Rabin Critique 13

1.4.3 First-Order Risk Aversion and Prospect Theory 14

1.5 Comparing Risks 15

1.5.1 Comparing Risks with the Same Mean 16

1.5.2 Comparing Risks with Different Means 18

1.5.3 The Principle of Diversification 19

1.6 Solution and Further Problems 20

2 Static Portfolio Choice 23

2.1 Choosing Risk Exposure 23

2.1.1 The Principle of Participation 23

2.1.2 A Small Reward for Risk 24

2.1.3 The CARA-Normal Case 25

2.1.4 The CRRA-Lognormal Case 27

2.1.5 The Growth-Optimal Portfolio 30

2.2 Combining Risky Assets 30

2.2.1 Two Risky Assets 31

2.2.2 One Risky and One Safe Asset 33

2.2.3 N Risky Assets 34

2.2.4 The Global Minimum-Variance Portfolio 35

2.2.5 The Mutual Fund Theorem 39

2.2.6 One Riskless Asset and N Risky Assets 39

2.2.7 Practical Difficulties 42

2.3 Solutions and Further Problems 43

3 Static Equilibrium Asset Pricing 47

3.1 The Capital Asset PricingModel (CAPM) 47

3.1.1 Asset Pricing Implications of the Sharpe-Lintner CAPM 48

3.1.2 The Black CAPM 50

3.1.3 Beta Pricing and Portfolio Choice 51

3.1.4 The Black-Litterman Model 54

3.2 Arbitrage Pricing and Multifactor Models 55

3.2.1 Arbitrage Pricing in a Single-Factor Model 55

3.2.2 Multifactor Models 59

3.2.3 The Conditional CAPM as a Multifactor Model 60

3.3 Empirical Evidence 61

3.3.1 Test Methodology 61

3.3.2 The CAPM and the Cross-Section of Stock Returns 66

3.3.3 Alternative Responses to the Evidence 72

3.4 Solution and Further Problems 77

4 The Stochastic Discount Factor 83

4.1 Complete Markets 83

4.1.1 The SDF in a Complete Market 83

4.1.2 The Riskless Asset and Risk-Neutral Probabilities 84

4.1.3 Utility Maximization and the SDF 85

4.1.4 The Growth-Optimal Portfolio and the SDF 85

4.1.5 Solving Portfolio Choice Problems 86

4.1.6 Perfect Risksharing 87

4.1.7 Existence of a Representative Agent 88

4.1.8 Heterogeneous Beliefs 89

4.2 Incomplete Markets 90

4.2.1 Constructing an SDF in the Payoff Space 90

4.2.2 Existence of a Positive SDF 92

4.3 Properties of the SDF 93

4.3.1 Risk Premia and the SDF 93

4.3.2 Volatility Bounds 95

4.3.3 Entropy Bound 100

4.3.4 Factor Structure 102

4.3.5 Time-Series Properties 102

4.4 Generalized Method of Moments 103

4.4.1 Asymptotic Theory 104

4.4.2 Important GMM Estimators 105

4.4.3 Traditional Tests in the GMM Framework 107

4.4.4 GMM in Practice 109

4.5 Limits of Arbitrage 112

4.6 Solutions and Further Problems 114

Part II Intertemporal Portfolio Choice and Asset Pricing

5 Present Value Relations 121

5.1 Market Efficiency 121

5.1.1 Tests of Autocorrelation in Stock Returns 124

5.1.2 Empirical Evidence on Autocorrelation in Stock Returns 125

5.2 Present Value Models with Constant Discount Rates 127

5.2.1 Dividend-Based Models 127

5.2.2 Earnings-Based Models 131

5.2.3 Rational Bubbles 132

5.3 Present Value Models with Time-Varying Discount Rates 134

5.3.1 The Campbell-Shiller Approximation 134

5.3.2 Short-and Long-Term Return Predictability 137

5.3.3 Interpreting US Stock Market History 140

5.3.4 VAR Analysis of Returns 143

5.4 Predictive Return Regressions 144

5.4.1 Stambaugh Bias 145

5.4.2 Recent Responses Using Financial Theory 146

5.4.3 Other Predictors 148

5.5 Drifting Steady-State Models 150

5.5.1 Volatility and Valuation 150

5.5.2 Drifting Steady-State Valuation Model 151

5.5.3 Inflation and the Fed Model 153

5.6 Present Value Logic and the Cross-Section of Stock Returns 153

5.6.1 Quality as a Risk Factor 154

5.6.2 Cross-Sectional Measures of the Equity Premium 154

5.7 Solution and Further Problems 156

6 Consumption-Based Asset Pricing 161

6.1 Lognormal Consumption with Power Utility 162

6.2 Three Puzzles 163

6.2.1 Responses to the Puzzles 166

6.3 Beyond Lognormality 168

6.3.1 Time-Varying Disaster Risk 173

6.4 Epstein-Zin Preferences 176

6.4.1 Deriving the SDF for Epstein-Zin Preferences 178

6.5 Long-Run Risk Models 182

6.5.1 Predictable Consumption Growth 182

6.5.2 Heteroskedastic Consumption 184

6.5.3 Empirical Specification 186

6.6 Ambiguity Aversion 187

6.7 Habit Formation 191

6.7.1 A Ratio Model of Habit 192

6.7.2 The Campbell-Cochrane Model 193

6.7.3 Alternative Models of Time-Varying Risk Aversion 198

6.8 Durable Goods 199

6.9 Solutions and Further Problems 201

7 Production-Based Asset Pricing 207

7.1 Physical Investment with Adjustment Costs 207

7.1.1 A q-Theory Model of Investment 208

7.1.2 Investment Returns 212

7.1.3 Explaining Firms’ Betas 214

7.2 General Equilibrium with Production 215

7.2.1 Long-Run Consumption Risk in General Equilibrium 215

7.2.2 Variable Labor Supply 220

7.2.3 Habit Formation in General Equilibrium 222

7.3 Marginal Rate of Transformation and the SDF 222

7.4 Solution and Further Problem 226

8 Fixed-Income Securities 229

8.1 Basic Concepts 230

8.1.1 Yields and Holding-Period Returns 230

8.1.2 Forward Rates 234

8.1.3 Coupon Bonds 236

8.2 The Expectations Hypothesis of the Term Structure 237

8.2.1 Restrictions on Interest Rate Dynamics 238

8.2.2 Empirical Evidence 239

8.3 Affine Term Structure Models 241

8.3.1 Completely Affine Homoskedastic Single-Factor Model 242

8.3.2 Completely Affine Heteroskedastic Single-Factor Model 245

8.3.3 Essentially Affine Models 246

8.3.4 Strong Restrictions and Hidden Factors 249

8.4 Bond Pricing and the Dynamics of Consumption Growth and Inflation 250

8.4.1 Real Bonds and Consumption Dynamics 250

8.4.2 Permanent and Transitory Shocks to Marginal Utility 252

8.4.3 Real Bonds, Nominal Bonds, and Inflation 254

8.5 Interest Rates and Exchange Rates 257

8.5.1 Interest Parity and the Carry Trade 258

8.5.2 The Domestic and Foreign SDF 260

8.6 Solution and Further Problems 264

9 Intertemporal Risk 269

9.1 Myopic Portfolio Choice 270

9.2 Intertemporal Hedging 272

9.2.1 A Simple Example 272

9.2.2 Hedging Interest Rates 273

9.2.3 Hedging Risk Premia 277

9.2.4 Alternative Approaches 283

9.3 The Intertemporal CAPM 283

9.3.1 A Two-Beta Model 283

9.3.2 Hedging Volatility: A Three-Beta Model 287

9.4 The Term Structure of Risky Assets 290

9.4.1 Stylized Facts 290

9.4.2 Asset Pricing Theory and the Risky Term Structure 291

9.5 Learning 295

9.6 Solutions and Further Problems 299

Part III Heterogeneous Investors

10 Household Finance 307

10.1 Labor Income and Portfolio Choice 308

10.1.1 Static Portfolio Choice Models 308

10.1.2 Multiperiod Portfolio Choice Models 312

10.1.3 Labor Income and Asset Pricing 316

10.2 Limited Participation 318

10.2.1 Wealth, Participation, and Risktaking 318

10.2.2 Asset Pricing Implications of Limited Participation 322

10.3 Underdiversification 323

10.3.1 Empirical Evidence 324

10.3.2 Effects on the Wealth Distribution 327

10.3.3 Asset Pricing Implications of Underdiversification 329

10.4 Responses to Changing Market Conditions 331

10.5 Policy Responses 334

10.6 Solutions and Further Problems 335

11 Risksharing and Speculation 341

11.1 Incomplete Markets 342

11.1.1 Asset Pricing with Uninsurable Income Risk 342

11.1.2 Market Design with Incomplete Markets 345

11.1.3 General Equilibrium with Imperfect Risksharing 346

11.2 Private Information 347

11.3 Default 349

11.3.1 Punishment by Exclusion 349

11.3.2 Punishment by Seizure of Collateral 353

11.4 Heterogeneous Beliefs 354

11.4.1 Noise Traders 354

11.4.2 The Harrison-Kreps Model 356

11.4.3 Endogenou Margin Requirements 359

11.5 Solution and Further Problems 363

12 Asymmetric Information and Liquidity 371

12.1 Rational Expectations Equilibrium 372

12.1.1 Fully Revealing Equilibrium 372

12.1.2 Partially Revealing Equilibrium 375

12.1.3 News, Trading Volume, and Returns 378

12.1.4 Equilibrium with Costly Information 380

12.1.5 Higher-Order Expectations 383

12.2 Market Microstructure 384

12.2.1 Information and the Bid-Ask Spread 385

12.2.2 Information and Market Impact 389

12.2.3 Diminishing Returns in Active Asset Management 392

12.3 Liquidity and Asset Pricing 392

12.3.1 Constant Trading Costs and Asset Prices 393

12.3.2 Random Trading Costs and Asset Prices 395

12.3.3 Margins and Asset Prices 396

12.3.4 Margins and Trading Costs 397

12.4 Solution and Further Problems 400

References 405

Index 435

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