## The Paradox Of Asset Pricing (2001)

Citations: | 20 - 2 self |

### BibTeX

@MISC{Bossaerts01theparadox,

author = {Peter Bossaerts},

title = {The Paradox Of Asset Pricing},

year = {2001}

}

### OpenURL

### Abstract

Modern finance has generated a set of formal models of the workings of financial markets that certainly excel in terms of mathematical elegance. But abstract beauty and logical appeal do not guarantee scientific validity. The illustrious late Richard Feynman, professor of physics at Caltech, made the same observation when he discussed the derivation of the law of gravitational potential energy from the "axiom" of conservation of energy. (See the above quote.) Fortunately for physicists, there is ample evidence that the law of gravitational potential energy is correct (to a certain degree). In contrast, there appears to be surprisingly little scientific support for even the most widely used financial model, namely, the CAPM. One can sympathize with E. Fama and K. French when they have recently begun to promote a pricing model that is based entirely on statistical regularities, even if it begs the question why it is more successful. To put this di#erently, asset pricing is paradoxical

### Citations

978 | The Equity Premium: A Puzzle
- Mehra, Prescott
- 1985
(Show Context)
Citation Context ...s, Lucas’ model indeed predicts little volatility. Contrast this with the actual volatility of securities prices in the real world, and one has a puzzle. This is part of the equity premium puzzle of=-= (Mehra and Prescott 1985) -=-that we will discuss in depth later on. Since the stationarity assumption is so crucial to Lucas’ model, and hence, to EMH, it is worth exploring how violations would affect the empirical findings. ... |

916 |
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- 1964
(Show Context)
Citation Context ...ber of basic portfolios, referred to as mutual funds. (See (Ross 1978).) This facilitated the development of asset pricing models. In particular, it lead to the Capital Asset Pricing Model (CAPM) of (=-=Sharpe 1964-=-, Lintner 1965, Mossin 1966). Given its importance in empirical research, we should pay attention to the static case. While we have been working in a dynamic context, it is fairly easily adjusted to a... |

624 |
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(Show Context)
Citation Context ...ess demand for a security is nonzero, the auctioneer calls out new prices, and a new round of demand revelation starts. The process stops if all markets 9 Market microstructure models, starting with (=-=Kyle 1985, Glos-=-ten and Milgrom 1985), study how a market discovers an asset’s “liquidation value,” and hence, could also be considered equilibrium price discovery models if the liquidation value is interpreted... |

595 |
An intertemporal capital asset pricing model
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(Show Context)
Citation Context ...te-time, stationary dynamic asset pricing models that have been derived over the last thirty years or so. There are other classes of asset pricing models, such as Merton’s continuous-time model (see=-= (Merton 1973-=-)), but these have been less important in empirical analysis. Still, the models we will consider here do capture the essence of all modern asset pricing theory, namely, that financial markets equilibr... |

478 | Games with Incomplete Information Played by Bayesian Players, I-III,”Management Science 14
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(Show Context)
Citation Context ...cing theory cannot ignore transient learning, even if based on asymptotics.sINTRODUCTION 107 cal. (In fact, this assumption is common in game theory, where it is known as the Harsanyi doctrine – see=-= (Harsanyi 1967-=-).) In general, there may be differences, and it is not immediately clear how they aggregate. (But see (Biais and Bossaerts 1998).) An investigation of this issue would distract us, so let us not elab... |

401 |
The Valuation of Risk Assets and the Selection of Risky Investments
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(Show Context)
Citation Context ...portfolios, referred to as mutual funds. (See (Ross 1978).) This facilitated the development of asset pricing models. In particular, it lead to the Capital Asset Pricing Model (CAPM) of (Sharpe 1964, =-=Lintner 1965-=-, Mossin 1966). Given its importance in empirical research, we should pay attention to the static case. While we have been working in a dynamic context, it is fairly easily adjusted to accommodate the... |

326 |
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(Show Context)
Citation Context ...ption that investors should be at least as good as the average economist, and hence, should be capable of working out equilibrium prices in any given state. The latter was first suggested by Muth in (=-=Muth 1961-=-). Still, to work out equilibrium prices in future states requires an enormous amount of structural knowledge about the economy that even the best economist does not have. It will be important for the... |

298 |
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- Lucas
- 1978
(Show Context)
Citation Context ...ke, both in preferences and beliefs, for in that case, aggregate and private consumption should be perfectly correlated (in equilibrium). We thus obtain Lucas’ consumption-based asset pricing model =-=((Lucas 1978)), which states that-=- the aggregate consumption at the beginning and end of each period, cA and c ′ A respectively, must be such that δE � ∂ũ(c ′ A ) ∂c ′ ∂ũ(cA) ∂c � Rn|x =1, (1.28) for all n. The as... |

297 |
The long-run performance of initial public offerings
- Ritter
- 1991
(Show Context)
Citation Context ...average returns than actually recorded in the first five months, and higher average returns than actually recorded in the period from one to four years after the IPO. A similar, more recent study is (=-=Ritter 1991-=-), based on 1,526 U.S. IPOs in the period 1975-84. Rather than evaluating the aftermarket performance of the IPOs against a specific model like the CAPM, (Ritter 1991) compared it to that of carefully... |

177 | Portfolio choice and asset prices: The importance of entrepreneurial risk - Heaton, Lucas - 2000 |

175 | Risk aversion and expected-utility theory: A calibration theorem
- Rabin
(Show Context)
Citation Context ... 1997) demonstrate theoretically that the quality of price discovery indeed increases when orders are introduced that allow agents to coordinate their trades across securities. 24See the analysis in (=-=Rabin 2000-=-) to get an idea of how powerful expected utility theory would become.s86 THE EXPERIMENTAL EVIDENCE Table 4.1 Typical Payoff Matrix Security State X Y Z A 170 370 150 B 160 190 250 Notes 100 100 100 o... |

156 | A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory - Roll - 1977 |

109 | Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth
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- 1989
(Show Context)
Citation Context ...ion is intertemporally complementary, and one refers to this situation as habit persistence. A continuous-time version of this class of preferences was studied, among others, in (Constantinides 1990, =-=Sundaresan 1989). To simplify notation, l-=-et The future equivalent carries a prime: z = x1 − y + λxs. z ′ = x ′ 1 − y ′ + λx ′ s. We’ll use double primes when referring to two periods in the future: z ′′ = x ′′ 1 − y... |

87 |
Existence of equilibrium of plans, prices and price expectations in a sequence of markets
- Radner
- 1972
(Show Context)
Citation Context ...ach state, write down what securities prices would be. One refers to this as the investors know the mapping from states to prices. This hypothesis has become known as rational expectations (RE). See (=-=Radner 1972-=-). In part, RE originates in the reasonable assumption that investors should be at least as good as the average economist, and hence, should be capable of working out equilibrium prices in any given s... |

84 |
Equilibrium in a Capital Asset
- Mossin
- 1966
(Show Context)
Citation Context ...ferred to as mutual funds. (See (Ross 1978).) This facilitated the development of asset pricing models. In particular, it lead to the Capital Asset Pricing Model (CAPM) of (Sharpe 1964, Lintner 1965, =-=Mossin 1966-=-). Given its importance in empirical research, we should pay attention to the static case. While we have been working in a dynamic context, it is fairly easily adjusted to accommodate the static model... |

76 |
Price Performance of Common Stock New Issues
- Ibbotson
- 1975
(Show Context)
Citation Context ...-84, in excess of the CAR on equity in established firms matched by size and industry, excluding the first day of trading. One exception is Ibbotson’s early study of IPO aftermarket performance. See=-= (Ibbotson 1975-=-). Ibbotson tested the CAPM on the average price change during each of the first 60 months after U.S. Initial Public Offerings (IPOs) of common stock in the period 60-69. He found that the CAPM predic... |

64 |
An Aggregation Theorem for Security Markets
- Rubinstein
- 1974
(Show Context)
Citation Context ...uld hold for aggregate consumption, otherwise the market is not in equilibrium (some investor, and hence, the aggregate investor, was not able to implement optimal consumption-investment plans). See (=-=Rubinstein 1974-=-) for a list of preferences for which aggregation obtains. It would distract us too far to elaborate on the technical aspects of either construction. The interested reader should consult the reference... |

50 |
On the exclusion of assets from tests of the two parameter model
- Stambaugh
- 1982
(Show Context)
Citation Context ...tive one’s conclusions are to the choice of market proxy (we took the value-weighted CRSP index). When staying within the class of widely traded securities, the conclusions appear to be insensitive =-=((Stambaugh 1982-=-)); when including nontraded wealth such as human capital, the conclusions can change dramatically ((Jagannathan and Whang 1996)). Practical applications of the CAPM almost invariably use proxies that... |

22 |
Mutual Fund Separation in Financial Theory: The separating Distributions
- Ross
- 1978
(Show Context)
Citation Context ...one meant that the optimal portfolio for a variety (or even all) of risk averse preferences could be obtained as a simple portfolio of a number of basic portfolios, referred to as mutual funds. (See (=-=Ross 1978-=-).) This facilitated the development of asset pricing models. In particular, it lead to the Capital Asset Pricing Model (CAPM) of (Sharpe 1964, Lintner 1965, Mossin 1966). Given its importance in empi... |

17 |
A Multiperiod Equilibrium Asset Pricing Model
- C, Subrahmanyam
- 1978
(Show Context)
Citation Context ...ideal. One could have chosen the CAPM, because of its status in empirical research, but this model is essentially static, i.e., it takes quite some effort to generate it as a dynamic model (but, see (=-=Stapleton and Subrahmanyam 1978, Ch-=-amberlain 1988, Bossaerts and Green 1989)). We studied Rubinstein’s model in Chapter 1, Section 7. Rubinstein’s model predicts the following for the relationship between the return on an asset n (... |

12 |
1989a. ‘Convergence of Least Squares Learning Mechanisms
- Marcet, Sargent
(Show Context)
Citation Context ...RE. Most of the analysis to date seems to have focused on how a market would learn the mapping from states to prices that is a crucial component of the RE equilibrium. Nice examples are (Jordan 1985, =-=Marcet and Sargent 1989-=-). Little attention is paid, however, to the question of how financial markets equilibrate given that this mapping is known, perhaps because one is in a static setting. We will see that there may be p... |

11 |
Risk and Return: An Experimental Analysis
- Levy
- 1997
(Show Context)
Citation Context ...rimental verification of asset pricing theory is a recent endeavor. Only very few economic experiments have ever been attempted that focused on the pricing and allocation of risk. There are, mainly, (=-=Levy 1997-=-, Bossaerts and Plott 2001, Bossaerts and Plott 1999, Bossaerts, Fine, and Ledyard 2000, Bossaerts, Plott, and Zame 2000). This chapter will demonstrate that experimental investigation of asset pricin... |

6 | Guu [2000], “Bifurcation Methods For Asset Market Equilibrium Analysis - Judd, M |

5 |
1962], “The Stability of The Competitive Equilibrium
- Negishi
(Show Context)
Citation Context ...of the stability of equilibrium: if an economy is kicked off its equilibrium, will it return towards it? There is an extensive literature on this in the context of the Arrow-Debreu model. See, e.g., (=-=Negishi 1962, -=-Arrow and Hahn 1971). But we have just concluded that our asset pricing models require a more sophisticated notion of equilibrium than the Walrasian equilibrium that is used in Arrow and Debreu’s wo... |

4 |
A.: Prognostic methods
- Lucas, Abu-Hanna
- 1999
(Show Context)
Citation Context ... issue of whether the optimal policy is Markovian. The reader is warned that the answer may be negative, and is referred for further information to excellent treatments in (Bertsekas and Shreve 1976, =-=Lucas and Stokey 1989-=-).sSTOCHASTIC DYNAMIC PROGRAMMING 5 If it exists and is measurable in xt, solving for the optimal policy yt in (1.3) is facilitated by the Bellman Principle, which states that there exists a sequence ... |

3 |
The cross-section of common stock returns: a review of the evidence and some new findings
- Hawawini, Keim
- 2000
(Show Context)
Citation Context ..., casting doubt on the external validity of the finding – see the discussion in (Cochrane 1999). Moreover, the weights on the indices are even different across countries during the same time period =-=((Hawawini and Keim 1998))-=-. Confirming one’s suspicion that this line of research exploits mathematical facts, (Berk 1995) argues that two pieces of the portfolio, (ii) and (iii), exploit the fact that market capitalization ... |

3 | Learning Rational Expectations: The Finite State Case
- JORDAN
- 1985
(Show Context)
Citation Context ...rld, namely, RE. Most of the analysis to date seems to have focused on how a market would learn the mapping from states to prices that is a crucial component of the RE equilibrium. Nice examples are (=-=Jordan 1985-=-, Marcet and Sargent 1989). Little attention is paid, however, to the question of how financial markets equilibrate given that this mapping is known, perhaps because one is in a static setting. We wil... |

1 |
Yes, The Capm Is Well And Alive
- Jagannathan, Whang
- 1996
(Show Context)
Citation Context ...in the class of widely traded securities, the conclusions appear to be insensitive ((Stambaugh 1982)); when including nontraded wealth such as human capital, the conclusions can change dramatically ((=-=Jagannathan and Whang 1996-=-)). Practical applications of the CAPM almost invariably use proxies that only include widely traded securities. Like the CRSP value-weighted index, such proxies have generally been found to be mean-v... |