The Paradox of Asset Pricing

by Peter Bossaerts

Overview

Asset pricing theory abounds with elegant mathematical models. The logic is so compelling that the models are widely used in policy, from banking, investments, and corporate finance to government. To what extent, however, can these models predict what actually happens in financial markets? In The Paradox of Asset Pricing, a leading financial researcher argues forcefully that the empirical record is weak at best. Peter Bossaerts undertakes the most thorough, technically sound investigation in many years into the scientific character of the pricing of financial assets. He probes this conundrum by modeling a decidedly volatile phenomenon that, he says, the world of finance has forgotten in its enthusiasm for the efficient markets hypothesis—speculation.


Bossaerts writes that the existing empirical evidence may be tainted by the assumptions needed to make sense of historical field data or by reanalysis of the same data. To address the first problem, he demonstrates that one central assumption—that markets are efficient processors of information, that risk is a knowable quantity, and so on—can be relaxed substantially while retaining core elements of the existing methodology. The new approach brings novel insights to old data. As for the second problem, he proposes that asset pricing theory be studied through experiments in which subjects trade purposely designed assets for real money. This book will be welcomed by finance scholars and all those math—and statistics-minded readers interested in knowing whether there is science beyond the mathematics of finance.


This book provided the foundation for subsequent journal articles that won two prestigious awards: the 2003 Journal of Financial Markets Best Paper Award and the 2004 Goldman Sachs Asset Management Best Research Paper for the Review of Finance.

Product Details

ISBN-13:	9780691123134
Publisher:	Princeton University Press
Publication date:	01/17/2005
Series:	Frontiers of Economic Research
Edition description:	New Edition
Pages:	192
Product dimensions:	6.00(w) x 9.25(h) x (d)
Age Range:	18 Years

About the Author

Peter Bossaerts is William D. Hacker Professor of Economics and Management, Professor of Finance, and Executive Officer for the Social Sciences at the California Institute of Technology. He is the coauthor of Lectures on Corporate Finance.

Table of Contents

	Preface	ix
1	Principles of Asset-Pricing Theory
1.1	Introduction	1
1.2	Stochastic Dynamic Programming	2
1.3	An Application to a Simple Investment-Consumption Problem	8
1.4	A Nontrivial Portfolio Problem	10
1.5	Portfolio Separation	11
1.6	Toward the First Asset-Pricing Model	15
1.7	Consumption-Based Asset-Pricing Models	17
1.8	Asset-Pricing Theory: The Bottom Line	21
1.9	Arrow-Debreu Securities Pricing	22
1.10	Roll's Critique	23
1.11	Time Nonseparable Preferences	24
1.12	Existence of Equilibrium	26
1.13	Price Discovery	28
	Exercises	36
2	Empirical Methodology
2.1	Introduction	39
2.2	The Efficient Markets Hypothesis (EMH)	42
2.3	Violations of the Stationarity Assumption	46
2.4	Inference in a Nonstationary World	53
2.5	Testing the CAPM	55
2.5.1	A Linear Test	56
2.5.2	A Nonlinear Test	57
2.5.3	The Fama-MacBeth Procedure	58
2.5.4	Can One Condition on Less than the Entire State Vector in Tests of the CAPM?	59
2.6	Testing Consumption-Based Asset-Pricing Models	63
2.7	Diagnostics: Variance Bounds	66
	Exercises	69
3	The Empirical Evidence in a Nutshell
3.1	Introduction	71
3.2	Empirical Evidence on the CAPM	72
3.3	Hansen-Jagannathan Bounds	83
3.4	GMM Tests of Consumption-Based Models	89
3.5	Cross-Sectional Tests	95
3.6	Conclusion	100
	Exercises	101
4	The Experimental Evidence
4.1	Introduction	103
4.2	A Typical Asset-Pricing Experiment	107
4.3	Theoretical Predictions	110
4.4	Experimental Results	111
4.5	Announced and Perceived Uncertainty	116
4.6	The Scale of Experimentation	122
4.7	Formal Tests	124
4.7.1	The CAPM	124
4.7.2	The Arrow-Debreu Model	126
4.8	Conclusion	128
5	From EMH to Merely Efficient Learning
5.1	Introduction	131
5.2	Bayesian Learning	137
5.3	Digital Option Prices under ELM	140
5.4	Limited Liability Security Prices under ELM	142
5.5	Revisiting an Earlier Example	147
5.6	Conclusion	151
	Exercises	152
6	Revisiting the Historical Record
6.1	Introduction	153
6.2	U.S. IPO Aftermarket Performance	154
6.3	Conclusion	162
	References	163
	Index	169

What People are Saying About This

Bernt Arne Odegaard

An important and timely book, The Paradox of Asset Pricing offers a fresh look at what the efficient markets hypothesis really implies. Summarizing forty years of asset pricing tests, it compels researchers to think deeply about what they are doing.
— Bernt Arne Odegaard, Norwegian School of Management, Central Bank of Norway

From the Publisher

"This book, whose rousing style drew me in immediately, is remarkable in how well it is able honestly to convey the core of modern finance theory and then to go on to criticize it fairly."—Thomas Sargent, Stanford University, Hoover Institution

"An important and timely book, The Paradox of Asset Pricing offers a fresh look at what the efficient markets hypothesis really implies. Summarizing forty years of asset pricing tests, it compels researchers to think deeply about what they are doing."—Bernt Arne Odegaard, Norwegian School of Management, Central Bank of Norway

Thomas Sargent

This book, whose rousing style drew me in immediately, is remarkable in how well it is able honestly to convey the core of modern finance theory and then to go on to criticize it fairly.
— Thomas Sargent, Stanford University, Hoover Institution

Editorial Reviews

"This book, whose rousing style drew me in immediately, is remarkable in how well it is able honestly to convey the core of modern finance theory and then to go on to criticize it fairly."—Thomas Sargent, Stanford University, Hoover Institution

From the Publisher