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652
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 184 (0 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
Does option compensation increase managerial risk appetite
 Journal of Finance
, 2000
"... This paper solves the dynamic investment problem of a risk averse manager compensated with a call option on the assets he controls. Under the manager’s optimal policy, the option ends up either deep in or deep out of the money. As the asset value goes to zero, volatility goes to infinity. However, t ..."
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Cited by 182 (0 self)
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This paper solves the dynamic investment problem of a risk averse manager compensated with a call option on the assets he controls. Under the manager’s optimal policy, the option ends up either deep in or deep out of the money. As the asset value goes to zero, volatility goes to infinity. However, the option compensation does not strictly lead to greater risk seeking. Sometimes, the manager’s optimal volatility is less with the option than it would be if he were trading his own account. Furthermore, giving the manager more options causes him to reduce volatility. MANAGERS WITH CONVEX COMPENSATION SCHEMES play an important role in financial markets. This paper solves for the optimal dynamic investment policy for a risk averse manager paid with a call option on the assets he controls. The paper focuses on how the option compensation impacts the manager’s appetite for risk when he cannot hedge the option position. On one hand, the convexity of the option makes the manager shun payoffs that are likely to be near the money. Under the optimal policy, the manager
Electricity prices and power derivatives.  Evidence from the Nordic Power Exchange.
 Review of Derivatives Research
, 2000
"... This paper examines the importance of the regular patterns in the behavior of electricity prices, and its implications for the purposes of derivative pricing. We analyze the Nordic Power Exchange's spot, futures, and forward prices. We conclude that the seasonal systematic pattern throughout ..."
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Cited by 166 (1 self)
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This paper examines the importance of the regular patterns in the behavior of electricity prices, and its implications for the purposes of derivative pricing. We analyze the Nordic Power Exchange's spot, futures, and forward prices. We conclude that the seasonal systematic pattern throughout the year, in particular, is of crucial importance in explaining the shape of the futures/forward curve. Moreover, in the context of the one factor models analyzed in this paper, actual futures and forward prices are best explained by a sinusoidal function in order to capture the seasonal behavior directly implied by spot electricity prices. 1 Respectively, Dpto. Economa Financiera y Matemtica, Universidad de Valencia, Avda. de los Naranjos s/n, 46022Valencia, Spain, and The Anderson School at UCLA, Box 951481, Los Angeles, CA 900951481, USA. We are grateful to Felipe Aguerrevere, M. Dolores Furi, Javier Gmez Biscarri, and Vicente Meneu for helpful comments. This paper was completed while...
Intertemporally dependent preferences and the volatility of consumption and wealth
 Review of Financial Studies
, 1989
"... In this article we construct a model in which a consumer’s utility depends on the consumption history We describe a general equilibrium framework similar to Cox, Ingersoll, and Ross (1985a). A simple example is then solved in closedform in this general equilibrium setting to rationalize the observed ..."
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Cited by 165 (3 self)
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In this article we construct a model in which a consumer’s utility depends on the consumption history We describe a general equilibrium framework similar to Cox, Ingersoll, and Ross (1985a). A simple example is then solved in closedform in this general equilibrium setting to rationalize the observed stickiness of the consumption series relative to the fluctuations in stock market wealth. The sample paths of consumption generated from this model imply lower variability in consumption growth rates compared to those generated by models with separable utilizations. We then present a partial equilibrium model similar to Merton (1969, 1971) and extend Merton’s results on optimal consumption and portfolio rules to accommodate nonseparability in preferences. Asset pricing implications of our framework are briefly explored. The idea that a given bundle of consumption goods will provide the same level of satisfaction at any date regardless of one’s past consumption experience is implicit in models that use timeseparable utility functions to represent preferences. Separable utility functions have been the mainstay in much of the literature on asset pricing and optimal consumption and portfolio The results reported in this article were first presented at the EFA meetings in Bern, Switzerland, in 1985 [see Sundaresan (1984)]. Subsequently the article was presented at a number of universities and conferences. I thank the participants at those presentations for their feedback. I am especially thankful to Doug Breeden, Michael Brennan, John Cox, Chifu Huang, and Krishna Ramaswamy for their thoughtful comments and criticisms. I also thank Tongsheng Sun for explaining the simulation procedure for stochastic differential equations and for his comments and suggestions. I am responsible for any remaining errors. Correspondence should be sent to Suresh M. Sundaresan, Graduate
Does net buying pressure affect the shape of implied volatility functions
 Journal of Finance
, 2004
"... This paper examines the relation between net buying pressure and the shape of the implied volatility function (IVF) for index and individual stock options. We find that changes in implied volatility are directly related to net buying pressure from public order flow. We also find that changes in impl ..."
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Cited by 144 (3 self)
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This paper examines the relation between net buying pressure and the shape of the implied volatility function (IVF) for index and individual stock options. We find that changes in implied volatility are directly related to net buying pressure from public order flow. We also find that changes in implied volatility of S&P 500 options are most strongly affected by buying pressure for index puts, while changes in implied volatility of stock options are dominated by call option demand. Simulated deltaneutral optionwriting trading strategies generate abnormal returns that match the deviations of the IVFs above realized historical return volatilities. If people are willing to pay foolish prices for insurance, why shouldn’t we sell it to them? (Lowenstein (2000)). ONE OF THE MOST INTRIGUING ANOMALIES REPORTED in the derivatives literature is the “implied volatility smile. ” The name arose from the fact that, prior to the October 1987 market crash, the relation between the Black and Scholes (1973) implied volatility of S&P 500 index options and exercise price gave the ap
New Techniques to Extract Market Expectations from Financial Instruments
 Journal of Monetary Economics
, 1997
"... Central banks have several reasons for extracting information from asset prices. Asset prices may embody more accurate and more uptodate macroeconomic data than what is currently published or directly available to policy makers. Aberrations in some asset prices may indicate ..."
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Cited by 141 (4 self)
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Central banks have several reasons for extracting information from asset prices. Asset prices may embody more accurate and more uptodate macroeconomic data than what is currently published or directly available to policy makers. Aberrations in some asset prices may indicate
Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options
, 2001
"... This article provides several new insights into the economic sources of skewness. First, we document the differential pricing of individual equity options versus the market index, and relate it to variations in return skewness. Second, we show how risk aversion introduces skewness in the riskneutra ..."
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Cited by 127 (10 self)
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This article provides several new insights into the economic sources of skewness. First, we document the differential pricing of individual equity options versus the market index, and relate it to variations in return skewness. Second, we show how risk aversion introduces skewness in the riskneutral density. Third, we derive laws that decompose individual return skewness into a systematic component and an idiosyncratic component. Empirical analysis of OEX options and 30 stocks demonstrates that individual riskneutral distributions differ from that of the market index by being far less negatively skewed. This paper explains the presence and evolution of riskneutral skewness over time and in the crosssection of individual stocks.
Spanning and DerivativeSecurity Valuation
, 1999
"... This paper proposes a methodology for the valuation of contingent securities. In particular, it establishes how the characteristic function (of the future uncertainty) is basis augmenting and spans the payoff universe of most, if not all, derivative assets. In one specific application, from the char ..."
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Cited by 117 (6 self)
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This paper proposes a methodology for the valuation of contingent securities. In particular, it establishes how the characteristic function (of the future uncertainty) is basis augmenting and spans the payoff universe of most, if not all, derivative assets. In one specific application, from the characteristic function of the stateprice density, it is possible to analytically price options on any arbitrary transformation of the underlying uncertainty. By differentiating (or translating) the characteristic function, limitless pricing and/or spanning opportunities can be designed. As made lucid via example contingent claims, by exploiting the unifying spanning concept, the valuation approach affords substantial analytical tractability. The strength and versatility of the methodology is inherent when valuing (1) Averageinterest options; (2) Correlation options; and (3) Discretelymonitored knockout options. For each optionlike security, the characteristic function is strikingly simple (although the corresponding density is unmanageable/indeterminate). This article provides the economic foundations for valuing derivative securities.
Implementing ArrowDebreu Equilibria by Continuous Trading of Few LongLived Securities
 Econometrica
, 1986
"... Equilibrium model of an dynamic economy extending over an in nite sequence of dates plays an important role in modern economic theory. The basic equilibrium concept in such model is the ArrowDebreu (or Walrasian) competitive equilibrium. In an ArrowDebreu equilibrium it is assumed that agents can ..."
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Cited by 102 (9 self)
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Equilibrium model of an dynamic economy extending over an in nite sequence of dates plays an important role in modern economic theory. The basic equilibrium concept in such model is the ArrowDebreu (or Walrasian) competitive equilibrium. In an ArrowDebreu equilibrium it is assumed that agents can simultaneously trade