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56
Asset pricing at the millennium
 Journal of Finance
"... This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior ..."
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Cited by 123 (3 self)
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This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior of the term structure of real interest rates restricts the conditional mean of the SDF, whereas patterns of risk premia restrict its conditional volatility and factor structure. Stylized facts about interest rates, aggregate stock prices, and crosssectional patterns in stock returns have stimulated new research on optimal portfolio choice, intertemporal equilibrium models, and behavioral finance. This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work. Theorists develop models with testable predictions; empirical researchers document “puzzles”—stylized facts that fail to fit established theories—and this stimulates the development of new theories. Such a process is part of the normal development of any science. Asset pricing, like the rest of economics, faces the special challenge that data are generated naturally rather than experimentally, and so researchers cannot control the quantity of data or the random shocks that affect the data. A particularly interesting characteristic of the asset pricing field is that these random shocks are also the subject matter of the theory. As Campbell, Lo, and MacKinlay ~1997, Chap. 1, p. 3! put it: What distinguishes financial economics is the central role that uncertainty plays in both financial theory and its empirical implementation. The starting point for every financial model is the uncertainty facing investors, and the substance of every financial model involves the impact of uncertainty on the behavior of investors and, ultimately, on mar* Department of Economics, Harvard University, Cambridge, Massachusetts
Transaction costs and predictability: Some utility cost calculations
 Journal of Financial Economics
, 1999
"... We examine the loss in utility for a consumer who ignores any or all of the following: (1) the multiperiod nature of the consumer's portfoliochoice problem, (2) the empirically documented predictability of asset returns, or (3) transaction costs. Both the costs of behaving myopically and ignoring ..."
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Cited by 90 (14 self)
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We examine the loss in utility for a consumer who ignores any or all of the following: (1) the multiperiod nature of the consumer's portfoliochoice problem, (2) the empirically documented predictability of asset returns, or (3) transaction costs. Both the costs of behaving myopically and ignoring predictability can be substantial, although allowing for intermediate consumption reduces these costs. Ignoring realistic transaction costs ("xed and proportional) imposes signi"cant utility costs that range from 0.8 % up to 16.9 % of wealth. For the scenarios that we consider, the presence of transaction costs always increases the utility cost of behaving myopically, but decreases the utility cost of
Optimal lifecycle asset allocation: understanding the empirical evidence
 Journal of Finance
, 2005
"... We show that a lifecycle model with realistically calibrated uninsurable labor income risk and moderate risk aversion can simultaneously match stock market participation rates and asset allocation decisions conditional on participation. The key ingredients of the model are Epstein–Zin preferences, ..."
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Cited by 83 (7 self)
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We show that a lifecycle model with realistically calibrated uninsurable labor income risk and moderate risk aversion can simultaneously match stock market participation rates and asset allocation decisions conditional on participation. The key ingredients of the model are Epstein–Zin preferences, a fixed stock market entry cost, and moderate heterogeneity in risk aversion. Households with low risk aversion smooth earnings shocks with a small buffer stock of assets, and consequently most of them (optimally) never invest in equities. Therefore, the marginal stockholders are (endogenously) more risk averse, and as a result they do not invest their portfolios fully in stocks. IN THIS PAPER, WE PRESENT A LIFECYCLE ASSET allocation model with intermediate consumption and stochastic uninsurable labor income that provides an explanation for two very important empirical observations: low stock market participation rates in the population as a whole, and moderate equity holdings for stock market participants. Our lifecycle model integrates three main motives that have been identified
Housing collateral, consumption insurance, and risk premia, Working paper
, 2002
"... In a model with housing collateral, the ratio of housing wealth to human wealth shifts the conditional distribution of asset prices and consumption growth. A decrease in house prices reduces the collateral value of housing, increases household exposure to idiosyncratic risk, and increases the condit ..."
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Cited by 58 (2 self)
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In a model with housing collateral, the ratio of housing wealth to human wealth shifts the conditional distribution of asset prices and consumption growth. A decrease in house prices reduces the collateral value of housing, increases household exposure to idiosyncratic risk, and increases the conditional market price of risk. Using aggregate data for the US, we find that a decrease in the ratio of housing wealth to human wealth predicts higher returns on stocks. Conditional on this ratio, the covariance of returns with aggregate risk factors explains eighty percent of the crosssectional variation in annual size and booktomarket portfolio returns. 1
The market price of aggregate risk and the wealth distribution, Working Paper
, 2001
"... I introduce bankruptcy into a complete markets model with a continuum of ex ante identical agents who have power utility. Shares in a Lucas tree serve as collateral. Bankruptcy gives rise to a second risk factor in addition to aggregate consumption growth risk. This liquidity risk is created by bind ..."
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Cited by 32 (4 self)
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I introduce bankruptcy into a complete markets model with a continuum of ex ante identical agents who have power utility. Shares in a Lucas tree serve as collateral. Bankruptcy gives rise to a second risk factor in addition to aggregate consumption growth risk. This liquidity risk is created by binding solvency constraints. The risk is measured by one moment of the wealth distribution, which multiplies the standard BreedenLucas stochastic discount factor. The economy is said to experience a negative liquidity shock when this growth rate is high, a large fraction of agents faces severely binding solvency constraints and the trading volume is low in financial markets. The adjustment to the BreedenLucas stochastic discount factor induces time variation in equity, bond and currency risk premia that is consistent with the data.
The 6D bias and the equity premium puzzle
 NBER Macroeconomics Annual
, 2001
"... If decision costs lead agents to update consumption every D periods, then econometricians will find an anomalously low correlation between equity returns and consumption growth (Lynch 1996). We analytically characterize the dynamic properties of an economy composed of consumers who have such delayed ..."
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Cited by 26 (2 self)
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If decision costs lead agents to update consumption every D periods, then econometricians will find an anomalously low correlation between equity returns and consumption growth (Lynch 1996). We analytically characterize the dynamic properties of an economy composed of consumers who have such delayed updating. In our setting, an econometrician using an Euler equation procedure would infer a coefficient of relative risk aversion biased up by a factor of 6D. Hence with quarterly data, if agents adjust their consumption every D =4quarters, the imputed coefficient of relative risk aversion will be 24 times greater than the true value. High levels of risk aversion implied by the equity premium and violations of the HansenJagannathan bounds cease to be puzzles. The neoclassical model with delayed adjustment explains the consumption behavior of shareholders. Once limited participation is taken into account, the model matches most properties of aggregate consumption and equity returns, including new evidence that the covariance between ln(Ct+h/Ct) and Rt+1 slowly rises with h.
When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and when is it not)?
, 2007
"... We construct a model with a large number of agents who have constant relative risk aversion (CRRA) preferences. We show that the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent o ..."
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Cited by 24 (4 self)
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We construct a model with a large number of agents who have constant relative risk aversion (CRRA) preferences. We show that the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks and aggregate consumption growth is independent over time. In the equilibrium, which features trade and binding solvency constraints, as opposed to Constantinides and Duffie (1996), households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore we show that the crosssectional wealth and consumption distributions are not affected by aggregate shocks. Equilibrium consumption allocations can be obtained by solving for an equilibrium in a version of the model without aggregate shocks, as in Bewley (1986), and then rescaling the allocation by aggregate income. These results hold regardless of the persistence of idiosyncratic shocks, and arise even when households face tight solvency constraints, but only a weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.
Testing for MeanVariance Spanning: A Survey
 JOURNAL OF EMPIRICAL FINANCE
, 2001
"... In this paper we present a survey on the various approaches that can be used to test whether the meanvariance frontier of a set of assets spans or intersects the frontier of a larger set of assets. We analyze the restrictions on the return distribution that are needed to have meanvariance spanning ..."
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Cited by 11 (1 self)
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In this paper we present a survey on the various approaches that can be used to test whether the meanvariance frontier of a set of assets spans or intersects the frontier of a larger set of assets. We analyze the restrictions on the return distribution that are needed to have meanvariance spanning or intersection. The paper explores the duality between meanvariance frontiers and volatility bounds, analyzes regression based test procedures for spanning and intersection, and shows how these regression based tests are related to tests for meanvariance efficiency, performance measurement, optimal portfolio choice, and specification error bounds.
The Sharpe Ratio and Preferences: A Parametric Approach”, mimeo
, 2000
"... We use a lognormal framework to examine the effect of preferences on the market price for risk, that is, the Sharpe ratio. In our framework, the Sharpe ratio can be calculated directly from the elasticity of the stochastic discount factor with respect to consumption innovations as well as the volat ..."
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Cited by 9 (4 self)
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We use a lognormal framework to examine the effect of preferences on the market price for risk, that is, the Sharpe ratio. In our framework, the Sharpe ratio can be calculated directly from the elasticity of the stochastic discount factor with respect to consumption innovations as well as the volatility of consumption innovations. This can be understood as an analytical shortcut to the calculation of the Hansen–Jagannathan volatility bounds, and therefore provides a convenient tool for theorists searching for models capable of explaining assetpricing facts. To illustrate the usefulness of our approach, we examine several popular preference specifications, such as CRRA, various types of habit formation, and the recursive preferences of Epstein–Zin–Weil. Furthermore, we show how the models with idiosyncratic consumption shocks can be studied.
2012, ‘Bond Liquidity Premia
 Review of Financial Studies
"... Recent models of limits to arbitrage imply that the tightness of funding conditions faced by financial intermediaries is a component of the pricing kernel. In the US, the repo market is the key funding market for traders and arbitrageurs implying in turn that the ontherun premium shares a common c ..."
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Cited by 8 (1 self)
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Recent models of limits to arbitrage imply that the tightness of funding conditions faced by financial intermediaries is a component of the pricing kernel. In the US, the repo market is the key funding market for traders and arbitrageurs implying in turn that the ontherun premium shares a common component with the risk premia observed in other markets. This observation leads to the following identification strategy. We measure the value of liquidity from the crosssection of ontherun premia by adding a liquidity factor to an arbitragefree term structure model. As predicted, we find that liquidity value affects the crosssection of risk premia at quarterly and annual horizons. An increase in the value of liquidity predicts lower risk premia for ontherun and offtherun bonds but higher risk premia on Libor loans, swap contracts and corporate bonds. Moreover, the measured impact is pervasive through crisis and normal times. Finally, we find that liquidity value varies with changes in aggregate uncertainty, measured from S&P500 options, and with changes in monetary stance, measured from bank reserves and monetary aggregates. These linkages are consistent with the theory and suggest that different securities serve, in part, and to varying degrees, to fulfill investors ’ uncertain future needs for cash.