John H. Cochrane
!
Graduate School of Business
University of Chicago
1101 E. 58th St.
Chicago IL 60637
john.cochrane@gsb.uchicago.edu
March 26, 2001
This is a very preliminary draft; its incomplete and Im sure full of typos. Still, I welcome comments
on any problems you nd with these notes.
1 Problems for Chapter 1
1. a and b are trivial. For c,
c
2
/c
1
d(c
1
/c
2
)
dR/R
= !
dc
1
c
1
!
dc
2
c
2
dR
R
.
The rst order conditions are
u
0
(c
1
) = !
"u
0
(c
2
) =
!
R
.
Di!erentiating the rst order conditions,
#
dc
1
c
1
=
c
1
u
00
(c
1
)
u
0
(c
1
)
dc
1
c
1
=
d!
!
#
dc
2
c
2
=
c
2
u
00
(c
2
)
u
0
(c
2
)
dc
2
c
2
=
d!
!
!
dR
R
2. The expected return of the asset is the same as that of its mimicking portfolio, proj(Rm)
3.
(a) We know there are a, b, such that m = a +bR
mv
. Determine a,b, by pricing R
mv
and the risk
free rate R
f
1 = E(mR
mv
) = E[(a +bR
mv
) (R
mv
)]
1 = E(mR
f
) =
h
E(a +bR
mv
)R
f
i
!
Copyright c John H. Cochrane 2001
1
1 = aE(R
mv
) +bE
R
mv2
1 = aR
f
+bE(R
mv
)R
f
a =
E(R
mv
)R
f
!E(R
mv2
)
E(R
mv
)
2
R
f
!E(R
mv2
)R
f
=
E(R
mv2
) !E(R
mv
)R
f
R
f
var(R
mv
)
=
var(R
mv
) +
E(R
mv
) !R
f
E(R
mv
)
R
f
var(R
mv
)
=
1
R
f
!
"
1 +
E(R
mv
) !R
f
E(R
mv
)
var(R
mv
)
#
$
b =
E(R
mv
) !R
f
E(R
mv
)
2
R
f
!E(R
mv2
)R
f
= !
1
R
f
E(R
mv
) !R
f
var(R
mv
)
b = !
1
R
f
E(R
mv
) !R
f
var(R
mv
)
a =
1
R
f
!bE(R
mv
).
An easier way to do this is to parameterize the linear function by a mean and shock:
$ = 1 : m = E(m) +a(R
mv
!E(R
mv
))
E(m) = 1/R
f
: m = 1/R
f
+a(R
mv
!E(R
mv
))
1 = E(mR
mv
) : 1 =
E(R
mv
)
R
f
+a%
2
(R
mv
)
a = !
E(R
mv
) !R
f
R
f
%
2
(R
mv
)
m =
1
R
f
!
E(R
mv
) !R
f
R
f
%
2
(R
mv
)
(R
mv
!E(R
mv
))
(b) We had
E(R
i
) = R
f
+"
i,m
!
m
We have
cov(R
i
, a +bR
mv
) = bcov(R
i
, R
mv
).
4. No. The Sharpe ratio bound applies to any excess return
E(R
i
) !E(R
j
)
%(R
i
!R
j
)
"
%(m)
E(m)
=
E(R
mv
) !R
f
%(R
mv
)
5.
%
(c
t+1
/c
t
)
"!
=
q
E(e
"2!!lnc
t+1
) !E(e
"!!lnc
t+1
)
2
=
q
e
"2!E(!lnc
t+1
)+2!
2
"
2
(!lnc
t+1
)
!e
"2!E(!lnc
t+1
)+!
2
"
2
(!lnc
t+1
)
= e
"!E(!lnc
t+1
)+
1
2
!
2
"
2
(!lnc
t+1
)
q
e
!
2
"
2
(!lnc
t+1
)
!1
E
h
(c
t+1
/c
t
)
"!
i
= E
e
"! ln!c
t+1
= e
"!E(!lnc
t+1
)+
1
2
!
2
"
2
(!lnc
t+1
)
.
Dividing, we get the rst result. For the second result, use the approximation for small x that
e
x
# 1 +x.
2
6. You wouldnt put all your money in such an asset, but you might well put some of your money in
such an asset if it provides insurance if its beta is low. (Graph!)
7.
(a) Rather obviously, use the equation at t and t + 1, i.e. start with
p
t+1
= E
t+1
"
u
0
(c
t+2
)
u
0
(c
t+1
)
d
t+2
+"
2
u
0
(c
t+3
)
u
0
(c
t+1
)
d
t+3
+...
"
u
0
(c
t+1
)
u
0
(c
t
)
p
t+1
+E
t
"
u
0
(c
t+1
)
u
0
(c
t
)
d
t+1
= E
t
"
2
u
0
(c
t+2
)
u
0
(c
t
)
p
t+2
+E
t
"
2
u
0
(c
t+2
)
u
0
(c
t
)
d
t+2
+E
t
"
u
0
(c
t+1
)
u
0
(c
t
)
d
t+1
...
= E
t
#
X
j=1
"
j
u
0
(c
t+j
)
u
0
(c
t
)
d
t+j
+ lim
T$#
E
t
"
T
u
0
(c
t+T
)
u
0
(c
t
)
p
t+T
u
cc
dc +u
cl
dl +
1
2
u
ccc
dc
2
+
1
2
u
cll
dl
2
+u
ccl
dcdl
d"
"
= !&dt +
u
cc
u
c
dc +
u
cl
u
cc
dl +
1
2
u
ccc
u
c
dc
2
+
1
2
u
cll
u
c
dl
2
+
u
ccl
u
c
dcdl
3
After multiplication by dP/P only the dc and dl terms will have anything left, so
E
t
dp
p
+
D
p
dt !r
f
t
dt = E
t
dp
p
d"
"
=
u
cc
u
c
E
t
dp
p
dc
+
u
cl
u
c
E
t
dp
p
dl
or,
E
t
(R
i
) !R
f
#
u
cc
u
c
cov
t
(R
i
, c) +
u
cl
u
c
cov
t
(R
i
, l)
this is your rst view of a multifactor model, one with multiple betas or factors on the right hand
side. Of course, there is nothing deep about multiple factors the same model is expressed with the
single " on the right hand side. But there may be more economic intuition in having the c and l
separately rather than combining the two into ".
9.
1 = E(e
lnm+lnR
) > e
E(lnm)+E(lnR)
0 > E(lnm) +E(lnR)
!E(lnm) > E(lnR)
If you increase leverage ' in R = (1 !')R
f
+ 'R
m
you increase mean and volatility. If R can get
anywhere near zero, lnR goes o! to $. Thus, increasing ' eventually leads to a decrease in ElnR.
For example, if returns are normal, then
E(R) = e
E(lnR)+
1
2
"
2
(R)
lnE(R) = E(lnR) +
1
2
%
2
(R)
E(lnR) = lnE(R) !
1
2
%
2
(R)
E(lnR) = ln
h
'E(R
m
) + (1 !')R
f
i
!
1
2
'
2
%
2
(R
m
).
As ' increases, the second term eventually dominates.
2 Problems for Chapter 2
1.
(a)
p
t
= E
t
X
"
j
c
t+j
c
t
"!
c
t+j
p
t
c
t
= E
t
X
"
j
c
t+j
c
t
1"!
.
If # = 1,
p
c
= "/(1 !") =
1
&
where " = 1/(1 +&).
4
(b) If # < 1, then a rise in c
t+j
raises p
t
. If # > 1, however, a rise in c
t+j
lowers p
t
. Any piece of
news has two possible e!ects: cashows and discount rates. In this case the discount rate rises
faster than the payo!s, so the price actually declines.
2.
(a) The rst order conditions are
c
t
!c
!
= E
t
[R"(c
t+1
!c
!
)]
with R = 1 +r, and hence
c
t
= E
t
(c
t+1
) .
Iterate the technology forward,
k
t+2
= R(Rk
t
+i
t
) +i
t+1
= R
2
k
t
+Ri
t
+i
t+1
k
t+3
= R
3
k
t
+R
2
i
t
+Ri
t+1
+i
t+2
1
R
3
k
t+3
= k
t
+
1
R
i
t
+
1
R
i
t+1
+
1
R
2
i
t+2
"
3
k
t+3
= k
t
+"
h
i
t
+"i
t+1
+"
2
i
t+2
i
Continuing and with the transversality condition lim
T$#
"
T
k
t+T
= 0, and i = e !c
k
t
+
#
X
j=0
"
j+1
e
t+j
=
#
X
j=0
"
j+1
c
t+j
Taking expectations,
k
t
+
#
X
j=0
"
j+1
E
t
e
t+j
=
#
X
j=0
"
j+1
E
t
c
t+j
.
Intuitively, the present value of future consumption must equal wealth plus the present value of
future endowment (labor income).
The j + 1 comes from the timing, alas standard in the macro literature and national income
accounts . If you adopt the more common nance timing convention
k
t+1
= (1 +r) (k
t
+i
t
)
you get more natural present value formulas with "
j
.
Now, substitute the rst order condition in the budget constraint (production possibility frontier
if you want the General Equilibrium interpretation)
k
t
+
#
X
j=0
"
j+1
E
t
e
t+j
=
#
X
j=0
"
j+1
c
t
=
"
1
(1 !")
c
t
=
1
R
1
(1 !
1
R
)
c
t
=
1
R!1
c
t
=
c
t
r
c
t
= rk
t
+r
#
X
j=0
"
j+1
E
t
e
t+j
.
5
Consumption equals the annuity value of wealth (capital) rk
t
plus the present value of future
labor income (endowment). This is the permanent income hypothesis. It is not a partial
equilibrium result it is a general equilibrium model with linear technology and an endowment
income process.
Now to the random walk in consumption. Just quasirst di!erence, and use k
t+1
!k
t
= rk
t
+i
t
,
c
t
= rk
t
+r
"e
t
+"
2
E
t
e
t+1
+"
3
E
t
e
t+2
+...
c
t"1
= rk
t"1
+r
"e
t"1
+"
2
E
t"1
e
t
+"
3
E
t"1
e
t+1
+...
c
t
!c
t"1
= r(k
t
!k
t"1
) +...
c
t
!c
t"1
= r(rk
t"1
+e
t"1
!c
t"1
) +...
c
t
!c
t"1
= r
h
rk
t"1
+e
t"1
!rk
t"1
!r
"e
t"1
+"
2
E
t"1
e
t
+"
3
E
t"1
e
t+1
+...
i
+...
c
t
!c
t"1
= re
t"1
+r
"e
t
+"
2
E
t
e
t+1
+"
3
E
t
e
t+2
+...
r
2
+r
"e
t"1
+"
2
E
t"1
e
t
+"
3
E
t"1
e
t+1
+...
c
t
!c
t"1
= re
t"1
+r
"e
t
+"
2
E
t
e
t+1
+"
3
E
t
e
t+2
+...
!r
e
t"1
+"E
t"1
e
t
+"
2
E
t"1
e
t+1
+...
c
t
= c
t"1
+ (E
t
!E
t"1
) r"
#
X
j=0
"
j
e
t+j
.
Consumption is a random walk. Changes in consumption equal the innovation in the present
value of future income.
Bob Hall (1979) noticed the random walk nature of consumption in this model, and suggested
testing it by running regressions of #c
t
on any variable at time t!1. This paper was a watershed.
It is the rst Euler equation test of a model; note it does not require the full model solution
tying the shocks in #c
t
to fundamental taste and technology shocks the second term in our
random walk equation. The HansenSingleton (1982) Euler equation tests generalize to non
quadratic utility, random asset returns for which it is impossible to fully solve the model.
Technical details: I have assumed no free disposal  you follow the rst order conditions even if
past the bliss point. If you can freely dispose of consumption, then you will always end up at
the bliss point c
!
sooner or later. (Thanks to Ashley Wang for pointing this out. Hansen and
Sargents treatments of this problem deal with the bliss point issue.)
By the way, the algebra is much easier if you use lag operators, i.e. write c
t
= rk
t
+r"E
t
(1 !"L
"1
)
"1
e
t
.
But if you know how to do that, youve probably seen this model before.
(b)
c
t
= rk
t
+r
#
X
j=0
"
j+1
E
t
e
t+j
= rk
t
+r"
#
X
j=0
"
j
$
j
e
t
= rk
t
+
r"
1 !"$
e
t
.
c
t
= c
t"1
+ (E
t
!E
t"1
) r"
#
X
j=0
"
j
e
t+j
= c
t"1
+r"
#
X
j=0
"
j
$
j
(
t
= c
t"1
+
r"
1 !"$
(
t
.
The top equation does look like a consumption function, but notice that the parameter relating
consumption c to income e depends on the persistence of income e. It is not a psychological law
or a constant of nature. If the government changes policy so that income is more unpredictable
(i.e. it gets rid of the predictable part of recessions), then this coe$cient declines dramatically.
The income coe$cient is not policyinvariant. This is the basis of Bob Lucas (1974) dramatic
6
deconstruction of Keynesian models based on consumption functions that were used for policy
experiments.
In both equations, you see that consumption responds to permanent income and that as
shocks get more permanent as $ rises consumption moves more.
(c) R was the rate of return on technology. Despite the symbol, it is not (yet) the interest rate
the equilibrium rate of return on oneperiod claims to consumption. That remains to be proved.
The logic is, rst nd c, then price things from the equilibrium consumption stream. To be
precise and pedantic, call the risk free rate R
f
, and
1
R
f
t
= E
t
"
u
0
(c
t+1
)
u
0
(c
t
)
= "E
t
c
t+1
!c
!
c
t
!c
!
= "
c
t
!c
!
c
t
!c
!
= " =
1
R
Now, the fun stu!. We can approach the price of the consumption stream by brute force,
p
t
= E
t
#
X
j=1
m
t,t+j
c
t+j
= E
t
#
X
j=1
"
j
c
!
!c
t+j
c
!
!c
t
c
t+j
= E
t
#
X
j=1
"
j
c
!
c
t+j
!c
2
t+j
c
!
!c
t
=
#
X
j=1
"
j
c
!
c
t
!E
t
c
2
t+j
c
!
!c
t
=
#
X
j=1
"
j
c
!
c
t
!c
2
t
!var
t
(c
t+j
)
c
!
!c
t
c
t+1
= c
t
+
r"
1 !"$
(
t+1
c
t+2
= c
t
+
r"
1 !"$
((
t+1
+(
t+2
)
c
t+j
= c
t
+
r"
1 !"$
((
t+1
+.. +(
t+j
)
E
t
(c
t+j
) = c
t
(of course)
var
t
(c
t+j
) = j
r"
1 !"$
2
%
2
$
p
t
=
#
X
j=1
"
j
c
t
(c
!
!c
t
) !j
r%
1"%&
2
%
2
$
c
!
!c
t
=
#
X
j=1
"
j
%
&
'c
t
!
j
r%
1"%&
2
%
2
$
c
!
!c
t
(
)
*
=
!
"
#
X
j=1
"
j
#
$
c
t
!
!
"
#
X
j=1
j"
j
#
$
r%
1"%&
2
%
2
$
c
!
!c
t
#
X
j=1
j"
j
=
"
(" !1)
2
7
p
t
=
"
1 !"
c
t
!
"
(1 !")
2
r%
1"%&
2
%
2
$
c
!
!c
t
=
1
1+r
1 !
1
1+r
c
t
!
1
1+r
1 !
1
1+r
r%
1"%&
2
%
2
$
c
!
!c
t
p
t
=
1
r
c
t
!
"
(1 !"$)
2
1
c
!
!c
t
%
2
$
Wow. The rst term is the riskneutral price the value of a perpetuity paying c. (Dont forget
E
t
(c
t+j
) = c
t
) The second term is a risk correction. It lowers the price. If %
2
$
is high more risk
the price is lower. If $ is high more persistent consumption the price is lower.
Now, the hard term the e!ect of consumption. At the bliss point, the consumer is as happy
as can be, and marginal utility falls to zero. Hence, the consumer is innitely risk averse.
(u
00
(c)/u
0
(c) rises to innity). There is no consumption you can give him to compensate for risk,
since hes at the bliss point. No surprise that the price goes o! to !$ here. As consumption
rises towards the bliss point, the consumer gets more and more risk averse (u
00
is constant,
u
0
is falling), so the price declines. Above the bliss point, the consumer values consumption
negatively, so the price is higher than the riskneutral version.
This feature that risk aversion rises as consumption rises is obviously not a good one.
Quadratic utility is best used as a local approximation. Find a c
!
that gives a sensible risk
aversion, and then make sure the model doesnt get too far away!
The question says price as a function of e and k. Im curious how I ever got that, since it seems
a much more natural function of c. c is a function of e and k, of course, but substituting that
in does not seem very easy.
3. This is not only a historically important model, it introduces a very important method. Evaluating
innite sums as in the last problem is a huge pain. In most models, conditioning information is a
function of only a few state variables, x
t
. Everything you could want to know about the current state
of the economy, and the conditional distribution of everything you could want to know in the future
is contained in the state variables. Hence, prices (at least properly scaled) have to be a function
of the state variables. Instead of solving for p in terms of a huge innite sum, you can solve the
functional equation p(x) = E
t
[m
t,t+1
(x
t
, x
t+1
) (p(x
t+1
) +d
t+1
)]. Here we go...
(a) From the basic rst order condition,
p
b
t
= E
t
"u
0
(c
t+1
)/u
0
(c
t
) = E
t
"#c
"!
t+1
p
b
(#c
t
= h) = ")
h$h
h
"!
+")
h$l
l
"!
p
b
(#c
t
= l) = ")
l$h
h
"!
+")
l$l
l
"!
"
p
b
(#c
t
= h)
p
b
(#c
t
= l)
#
=
"
)
h$h
)
h$l
)
l$h
)
l$l
#"
"h
"!
"l
"!
#
p
b
= )x.
The riskfree rate is of course
R
f
= 1/p
b
.
8
(b) The consumption stream:
p
t
= E
t
h
"#c
"!
t+1
(p
t+1
+c
t+1
)
i
p
t
c
t
= "E
t
#c
1"!
t+1
p
t+1
c
t+1
+ 1
Solve this as a functional equation, as explained above. Find p/c in the h state and in the l
state (functions from two points to the real line are easy to determine you just nd the values
at the two points.)
p
c
(h) = ")
h$h
h
1"!
p
c
(h) + 1
+")
h$l
l
1"!
p
c
(l) + 1
"
p/c(h)
p/c(l)
#
= "
"
)
h$h
h
1"!
)
h$l
l
1"!
)
l$h
h
1"!
)
l$l
l
1"!
# "
1
1
#
+
"
p/c(h)
p/c(l)
#!
pc = ")
!
(1 +pc)
pc = (1 !")
!
)
"1
")
!
1
We can nd returns from
R
t+1
=
p
t+1
c
t+1
+ 1
pt
ct
c
t+1
c
t
.
Note when p/c is constant, R is just a constant times consumption growth. You need a very
small p/c before Ris much di!erent from consumption growth.
Conditionally expected returns follow from the probabilities.
(c) Start with the calibration. Its most natural to take the two points to be equally above and
below the mean, h = 1.01 +x, l = 1.01 !x and equal probabilities. Then, you want
1/2(1.01 +x) + 1/2(1.01 !x) = 1.01
1/2x
2
+ 1/2x
2
= 0.01
2
i.e., x = 0.01.
Here are my results.
In state
To state h l
# = 0.5
bond price 0.985 0.985
R
f
1.5% 1.5%
p/c 196 196
R h 2.52% 2.52%
l 0.51% 0.51%
# = 5
bond price 0.943 0.943
R
f
6.01 6.01
p/c 19.96 19.96
R h 7.11 7.11
l 5.01 5.01
9
The major failing is the equity premium. The mean stock return is almost exactly the same
as the riskfree rate. Also, stock returns are perfectly correlated with consumption growth.
The standard deviation of stock returns is about 1%, not about 20%. The Sharpe ratio
h
E(R) !R
f
i
/%(R) is way too low.
(d) To get serial correlation in consumption growth, I tried ) of the form
) =
"
1/2 +* 1/2 !*
1/2 !* 1/2 +*
#
Now,
E(dc
t+1
dc
t
= h) = (1/2 +*) % (g +x) + (1/2 !*) % (g !x) = g + 2*x
E(dc
t+1
dc
t
= l) = (1/2 !*) % (g +x) + (1/2 +*) % (g !x) = g !2*x
Here are my results for a positive serial correlation.
h l
# = 5, * = 0.1
p
b
0.934 0.953
R
f
7.07 4.97
p/c 19.93 20.3
R h 7.12 5.05
l 6.99 4.92
$(#c
t
, #c
t"1
) 0.21
.
The main reason I put this in at this stage is to get variation in prices with the initial state.
In the previous case, the world looks the same from any starting date, so there is no variation
in prices (exante). The interest rate and stock return are higher from the high state, because
expected future consumption growth is higher. Higher return means lower price or p/c.
3 Problems for Chapter 4
1. The absence of arbitrage implies the LOOP, but not vice versa.
NA&LOOP. Suppose the absence of arbitrage holds, but not the LOOP. Let z = ax + by. If
p(z) > ap(x)+bp(y), however, the portfolio z !(ax+by) is an arbitrage. In discount factor language,
if there is an m > 0, then there is an m. The LOOP theorem species an m in X, however. Given
an m, we can construct an m in X by x
!
= proj(mX).
LOOP&NA. In discount factor language, imagine a complete market with a discount factor that is
negative in some state of nature. This generates a set of prices that obey the law of one price, but
leave arbitrage opportunities. The corresponding set of prices and payo!s are a counterexample in
portfolio language.
2. The danger of applying the LOOP or no arbitrage in a sample is that you typically dont see all of the
possible realizations in any nite sample. For example, a corporate 10 year bond and a government
10 year bond will have identical payo!s in any sample in which the corporation does not default,
but the corporate bond will have a lower price. This looks like a violation of the law of one price.
HansenJagannathan bounds with positivity typically show arbitrage bound limits on the risk free
rate, which come from samples in which one security dominates another. These arbitrage bounds
disappear if one posits a distribution in which it is always possible for each security to underperform
the other.
10
(a) R
"1
is a discount factor. It is not necessarily in the payo! space, since that space is constructed
of linear combinations of the assets. x
!
is the unique discount factor in the payo! space, but
not the only discount factor. Often, R > 0, i.e. for limited liability securities like stocks. In this
case, R
"1
is always positive, but so is R/E(R
2
). Securities do not have to be limited liability,
so in general R
"1
can be negative. The biggest trouble with this discount factor is that it can
be innite if R = 0 can happen, in which case the expectation may not be dened. (It may be
out of the set of random variables with second moments).
(b) The rst order conditions are
E
1
'
0
R
R
= !.
Thus,
m =
1
!'
0
R
is a discount factor. In general, you cant solve the rst order conditions for ' analytically.
Another more beautiful way to do this. We know that every payo! in X can be priced by a
discount factor m > 0 State the problem as
maxE(ln(R)) s.t. 1 = E(mR)
max
X
)
i
ln(R
i
) s.t. 1 =
X
)
i
m
i
R
i
the rst order conditions choose R
i
in each state i are
)
i
1
R
i
= !)
i
m
i
1
R
i
= !m
i
Plugging this in to the constraint, you nd ! = 1. Thus, we have proved: the inverse return of
the portfolio that maximizes ln returns is equal to a discount factor.
(c) The latter approach is a quick way to do this in continuous time. A discount factor is a proces
" that prices payo!s at any date. Thus, consider the growth optimal trading strategy the
value process V that maximizes
maxE
ln
V
T
V
0
s.t. V
0
"
0
= E
t
[V
T
"
T
] .
Just as before, we have
V
T
V
0
=
"
0
"
T
.
This holds at any horizon, so V
t
is a numeraire a price process such that for any security priced
by ",
p
t
V
t
= E
t
Z
#
s=0
D
t+s
V
t+s
ds.
11
4 Problems for Chapter 5
1. You have to nd equations that express the right angles in the picture. Right angles means orthogonal
with second moment norm, so we want to prove that the line from any R
e
to its projection on R
e!
lies at right angles to R
e!
, E[(R
e
!proj(R
e
R
e!
)) R
e!
] = 0. Working on the latter expression,
E[(R
e
!proj(R
e
R
e!
)) R
e!
] = E[R
e
R
e!
!proj(R
e
R
e!
)R
e!
]
= E(R
e
R
e!
) !E(proj(R
e
R
e!
))
= E(R
e
) !E
E(R
e
R
e!
)
E(R
e!2
)
R
e!
= E(R
e
) !E
E(R
e
)
E(R
e!
)
R
e!
= 0.
I used the properties E(R
e!
R
e
) = 0 and E(R
e!2
) = E(R
e!
).
2. Start with a nonstochastic economy. In this case, x
!
is typically below the set of returns. x
!
is a
discount factor, so typically less than one. Returns are returns, hence typically greater than one.
Precisely, in a nonstochastic economy,
x
!
= 1/R
f
If R
f
> 1, then x
!
< 1 < R
f
. Its possible that R
f
< 1, if consumption is declining drastically, but
not typical.
Now, lets do it in a stochastic economy. R
!
is the return parallel to x
!
,
R
!
=
x
!
E(x
!2
)
; x
!
=
R
!
E(R
!2
)
.
so we just have to gure out if x
!
is longer or shorter than R
!
. Now, from the denitions,
x
!

2
= E(x
!2
) =
1
E(R
!2
)
=
1
R
!

2
x
!

2
R
!

2
= 1
Thus, x
!
 < R
!
 if R
!
 > 1 or if x
!
 < 1. This is very nice: In a nonstochastic economy x
!
R
f
= 1;
in a stochastic economy this generalizes to x
!
 R
!
 = 1.
So is the second moment of the return with smallest second moment greater or less than one? As you
can see in the drawing below, this can happen if risk premia (slope of the meanvariance frontier) is
high, and if the riskfree rate is low, not much more than 1.0.
12
Rf
MVF
R*
Std. Dev.
Mean
There are lots of ways to continue from here, to see if typical numbers give one of these conditions.
Easiest, by just looking at the frontier, I am able to show that
E(R
!2
) =
R
f2
E(R
e
)
"(R
e
)
2
+ 1
=
1.01
1 + 0.25
< 1
(1% is about the average real interest rate and stocks have averaged roughly 9% mean and 16%
standard deviation.) This means, we should actually expect x
!
to lie somewhat above the return
line.
Derivation:
E(R
2
) = E(R)
2
+%
2
(R) =
h
R
f
+E(R
e
)
i
2
+%
2
(R
e
)
where R
e
= R!R
f
;
= R
f2
+ 2R
f
E(R
e
) +E(R
e
)
2
+%
2
(R
e
)
= R
f2
+ 2R
f
E(R
e
) +E(R
e
)
2
+E(R
e
)
2
%(R
e
)
E(R
e
)
2
= R
f2
+ 2R
f
E(R
e
) +E(R
e
)
2
1 +
%(R
e
)
E(R
e
)
2
!
The minimum second moment return occurs (minimize over E(R
e
), holding Sharpe ratio constant)
occurs at
E(R
e
) = !
R
f
1 +
"(R
e
)
E(R
e
)
1 +
"(R
e
)
E(R
e
)
2
+
R
f2
1 +
"(R
e
)
E(R
e
)
1 +
%(R
e
)
E(R
e
)
2
!
13
E(R
!2
) = R
f2
!
+
"1 !
1
1 +
"(R
e
)
E(R
e
)
2
#
,
$
= R
f2
!
+
"
"(R
e
)
E(R
e
)
2
1 +
"(R
e
)
E(R
e
)
2
#
,
$ =
R
f2
E(R
e
)
"(R
e
)
2
+ 1
A little more formally, or using some of the tools and representations of the course, form x
!
x
!
= p
0
E(xx
0
)
"1
x
E(x
!2
) = p
0
E(xx
0
)
"1
p
Take the risk free rate and the market excess return as the elements of x,
x =
"
R
f
R
e
#
; p =
"
1
0
#
E(x
!2
) =
h
1 0
i
"
R
f2
R
f
E(R
e
)
E(R
e2
)
#
"1
"
1
0
#
E(x
!2
) =
1
R
f2
E(R
e2
) !R
f2
E(R
e
)
2
h
1 0
i
"
E(R
e2
) !R
f
E(R
e
)
!R
f
E(R
e
) R
f2
# "
1
0
#
E(x
!2
) =
1
R
f2
E(R
e2
)
%
2
(R
e
)
=
1
R
f2
E(R
e
)
2
+%
2
(R
e
)
%
2
(R
e
)
=
1
R
f2
"
1 +
E(R
e
)
2
%
2
(R
e
)
#
E(x
!2
) = 1/E(R
!2
) =
1
R
f2
"
1 +
E(R
e
)
2
%
2
(R
e
)
#
E(R
!2
) = R
f2
1
1 +
E(R
e
)
2
"
2
(R
e
)
To get some more intuition, price the risk free rate with x
!
,
1
R
f
= E(x
!
1) = E[proj(x
!
1)1]
Again, in a nonstochastic economy this reduces to x
!
= 1/R
f
and we learn that the projection of
x
!
on 1 should lie below the line of returns. But when there are large risk premia high Sharpe ratios;
large distortions between actual and risk neutral probabilities; large distortions between contingent
claims prices and probabilities the stochastic discount factor is very di!erent from a constant, so
x
!
itself must lie above Ras shown in the graph below. If you believe the size of the equity premium,
we live in an economy with severe distortions from risk neutrality, enough to get x
!
above the plane
of returns.
3. We already had from (5.20)
R
f
= R
!
+R
f
R
e!
.
Rearranging,
R
e!
= (R
f
!R
!
)/R
f
.
This is a useful formula to show that you can construct R
e!
from knowledge of R
!
and R
f
.
14
1
R
f
x*
R
Proj(x*1)
Figure 1:
4.
(a) R
!
and 1 are collinear, so R
e!
collapses to zero. The frontier collapses to a point, R
!
= R
f
. In
meanvariance space, all returns have the same mean, so the frontier collapses to a line, with
R
!
= R
f
at the leftmost point.
(b) The projection of 1 on R
e
is still zero, so R
!
is still the mean variance frontier. When the
payo!s are generated from x, R
e!
= E(x)
0
E(xx
0
)
"1
x. But if consumers are risk neutral, p(x) =
E(mx) = E(x) for all assets, so E(x) = 0 for excess returns and R
e!
= 0.
5. No. This is subtle. R
!
= x
!
/p(x
!
) = proj(mX)/p [proj(mX)]. R is a set, but not a space, since
it does not include zero, so you cant project on it. There is a rather general point in here. For
example, you dont form factormimicking portfolios by projecting on R, you project on X instead.
5 Problems for chapter 6
1. No. When the economy is riskneutral, R
e!
= 0. Thus, the frontier collapses to R
!
alone. Of course,
m = x
!
= 0 +
1
E(R
!2
)
R
!
is a discount factor, and is linear in the meanvariance e$cient return.
2. No. The " are di!erent, so the ! must also be di!erent. As a simple example, if the factor is 2 times
a return, then the factor mimicking portfolio is the return, so " is cut in half and ! doubles.
3. m is in X, so it is x
!
. R
!
= x
!
/p(x
!
) = (a !bR
m
) /
a/R
f
!b
.
4. They can stay the same. If you span the frontier by R
!
and R
f
, as you increase or decrease weight
on R
!
, you change the amount of one particular linear combination of factor mimicking portfolios,
but not the relative weights of the factors.
5. As in the text, nd y in R
!
+yR
e!
to generate zero covariance.
E[(R
!
+wR
e!
)(R
!
+yR
e!
)] = E(R
!
+wR
e!
)E(R
!
+yR
e!
)
E(R
!2
) +wyE(R
e!
) = E(R
!
)
2
+wyE(R
e!
)
2
+ (w +y)E(R
!
)E(R
e!
)
var(R
!
) +wy var(R
e!
) = (w +y)E(R
!
)E(R
e!
)
15
y =
var(R
!
) !wE(R
!
)E(R
e!
)
E(R
!
)E(R
e!
) !wvar(R
e!
)
6. In a riskneutral economy R
e!
= 0, so the whole meanvariance frontier, including the various risk
free rate proxies, collapses to the minimumvariance point R
!
. R
!
is not a constant no risk free
rate is traded. In a risk neutral economy, R
!
is the return closest to the unit vector.
6 Problems for Chapter 8
1. A risk free asset is on the conditional frontier. It is only on the unconditional frontier if it is constant.
R
f
t
= R
!
t+1
+R
f
t
R
e!
t+1
. The conditional mean variance frontier is R
!
+w
t
R
e!
so the risk free rate is
on the conditional mvf. The unconditional mvf is R
!
+wR
e!
. If the risk free rate is not constant, it
is not of this form.
Intuition: var(R) = var(E
t
(R)) +E(var
t
(R)). (Check it its a handy identity!) The risk free rate
has none of the second term, but if not constant some of the rst term. Other assets can get less
var(E
t
(R)) by accepting a little more E(var
t
(R)) for example the asset shown in the gure below.
The frontier is a line in meanstandard deviation space, but a parabola in meanvariance space. Thus,
near R
f
you get so much change in conditional mean per unit of added conditional variance, that
moving to an asset such as the one shown must get you towards a minimum unconditional variance
portfolio, on the unconditional frontier. Analytically, the conditional meanvariance frontier is a line
E
t
= R
f
r
+a%
t
. Thus, %
2
t
Et"R
f
r
a
2
= %
2
t
d%
2
t
/dE
t
= 2
Et"R
f
r
a
. Thus, at E
t
= R
f
, d%
2
t
/dE
t
= 0.
E
2
Info set 1
Info set 2
2. No. This is really the same question. Put another way, the unconditional meanvariance frontier will
not intersect the vertical axis. This happens all the time. The 3 month T bill rate is (nominally)
conditionally risk free. Yet a plot of the unconditional meanvariance frontier will not intersect the
vertical axis since the T bill rate varies over time. If youre running E(R) = # +"!, the question is, is
there is risk free rate to identify #, or must you use a zerobeta rate. Even if there is a conditionally
risk free rate, if it is not constant, the unconditional representation will need a zerobeta rate.
16
3. Neither, since you didnt include the managed portfolios. Unless, of course, everything is i.i.d. so
there are no instruments.
7 Problems for Chapter 9
1.
maxEu(c) st. c =
'
0
R
, '
0
1 = W
+
+'
i
: E
h
u
0
(c)R
i
i
= !
m
t+1
=
u
0
(c
t+1
)
!
t
=
c
!
!c
t+1
!
t
=
c
!
!R
W
t+1
W
t
!
t
2. This is a case where nitedimensional intuition can be misleading. If there were a nitedimensional
state space, then
min
{m}
(or max) p(x) = E(mx) s.t. m' 0, p(f) = E(mf)
would have nite upper and lower bounds. In an innitedimensional state space the typical case
for factor pricing as applied to equities it does not. Intuitively, there are no arbitrage portfolios of
stocks portfolios that dominate in every state of nature. Thus, the absence of negative prices for
such portfolios doesnt help us at all. (Problems like this generate arbitrage bounds in option pricing
problems. In option pricing, though, there are strictly dominating portfolios; a call option is better
in every state of nature than the portfolio that holds the stock and borrows the strike payment.)
3. No, it has to be the risk free rate, or a zerobeta rate. Heres the potential confusion. With a riskfree
rate, the CAPM is
E(R
i
) = R
f
+"
i,m
h
E(R
m
) !R
f
i
You can di!erence the left hand variables,
E(R
i
!R
j
) = "
i"j,m
h
E(R
m
) !R
f
i
Covariance is a linear operator, so "
i,m
!"
j,m
= "
i"j,m
. The question is whether we can do this on
the right hand side too. Can we write the CAPM in terms of an excess return on the right hand
side? Can we write
E(R
ei
) = "
i,R
m
"R
j E(R
m
!R
j
)?
Once posed, you can see that the answer is no. Betas are not linear in the denominator. In discount
factor language,
m = a !bR
m
cant be written
m = a !b(R
m
!R
j
)!
In fact, the CAPM is frequently tested with the Tbill rate as a proxy for the risk free rate. Though
the riskiness of the T bill rate does not matter for the left hand side, it does for the right. In practice,
this proxy is probably not a big deal
17
8 Problems for Chapter 11
1. Write the autocorrelation coe$cient as
$
j
=
E(x
t
!E(x
t
))(x
t"j
!E(x
t
))
E[(x
t
!E(x
t
))
2
]
=
E(x
t
x
t"j
) ![E(x
t
)]
2
E(x
2
t
) ![E(x
t
)]
2
Line up the required moments as
E
h
x
t
x
t"j
x
t
x
2
t
i
0
The derivatives we need are
+$
j
+E[x
t
x
t"j
]
=
1
E(x
2
t
) ![E(x
t
)]
2
=
1
%
2
(x)
+$
j
+E(x
t
)
=
!2
E(x
2
t
) ![E(x
t
)]
2
E(x
t
) + 2
E(x
t
x
t"j
) ![E(x
t
)]
2
E(x
t
)
n
E(x
2
t
) ![E(x
t
)]
2
o
2
= 2E(x
t
)
E(x
t
x
t"j
) !E(x
2
t
)
n
E(x
2
t
) ![E(x
t
)]
2
o
2
= 2E(x)
cov(x
t
x
t"j
)
%
4
(x)
= 2E(x)
$
j
%
2
(x)
+$
j
+E(x
2
t
)
=
!
E(x
t
x
t"j
) ![E(x
t
)]
2
n
E(x
2
t
) ![E(x
t
)]
2
o
2
= !
cov(x
t
x
t"j
)
%
4
(x)
= !
$
j
%
2
(x)
so
+,
+b
=
1
%
2
(x)
%
&
'
1
2E(x)$
j
!$
j
(
)
*
The S matrix is
S
j
=
#
X
k="#
E
%
&
'
x
t
x
t"j
x
t"k
x
t"j"k
x
t
x
t"j
x
t"k
x
t
x
t"j
x
2
t"k
x
t
x
t"k
x
t"k"j
x
t
x
t"k
x
t
x
2
t"k
x
2
t
x
t"k
x
t"k"j
x
2
t
x
t"k
x
2
t
x
2
t"k
(
)
*
The standard error is
var(corr
T
) =
1
T
+,
+
0
S
+,
+
x
2
t
x
3
t
0 E
x
3
t
x
4
t
(
)
*,
and $
j
= 0 in +,/+. Thus,
%
2
( $
j
) =
1
T
1
%
4
(x)
%
&
'
1
0
0
(
)
*
0
%
&
'
E(x
2
)
2
0 0
0 E
x
2
x
3
0 E
x
3
x
4
(
)
*
%
&
'
1
0
0
(
)
*
=
1
T
1
%
4
(x)
x
2
=
1
T
%
2
(x) +E(x)
2
2
%
4
(x)
18
If, in addition, E(x) = 0, we obtain the classic result: If the series is i.i.d. mean zero, the standard error
of the autocorrelation coe!cient is 1/
(
T. Of course, you can calculate standard errors without mean zero,
and without i.i.d.!
You can do the correlation coe$cient from p.207 the same way:
corr(x
t
, y
t
) = ,() =
E(x
t
, y
t
) !E(x
t
)E(y
t
)
q
E(x
2
t
) !E(x
t
)
2
q
E(y
2
t
) !E(y
t
)
2
= E(u
t
) =
h
E(x
t
) E(x
2
t
) E(y
t
) E(y
2
t
) E(x
t
y
t
)
i
0
var(corr
T
) =
1
T
+,
+
0
S
+,
+
S =
#
X
j="#
cov(u
t
, u
0
t"j
)
We need the derivatives,
+,
&
=
%
&
&
&
&
&
&
&
&
'
'(
'E(xt)
'(
'E(x
2
t
)
'(
'E(yt)
'(
'E(y
2
t
)
'(
'E(xtyt)
(
)
)
)
)
)
)
)
)
*
=
%
&
&
&
&
&
&
&
&
&
&
&
&
&
'
"E(yt)
(
E(x
2
t
)"E(xt)
2
(
E(y
2
t
)"E(yt)
2
+
E(xt,yt)"E(xt)E(yt)
(E(x
2
t
)"E(xt)
2
)
3
2
(
E(y
2
t
)"E(yt)
2
E(x
t
)
!
1
2
E(x
t
,y
t
)"E(x
t
)E(y
t
)
(E(x
2
t
)"E(xt)
2
)
3
2
(
E(y
2
t
)"E(yt)
2
"E(xt)
(
E(x
2
t
)"E(x
t
)
2
(
E(y
2
t
)"E(y
t
)
2
+
E(xt,yt)"E(xt)E(yt)
(
E(x
2
t
)"E(xt)
2
(E(y
2
t
)"E(yt)
2
)
3
2
E(y
t
)
!
1
2
E(x
t
,y
t
)"E(x
t
)E(y
t
)
(
E(x
2
t
)"E(xt)
2
(E(y
2
t
)"E(yt)
2
)
3
2
1
(
E(x
2
t
)"E(xt)
2
(
E(y
2
t
)"E(yt)
2
(
)
)
)
)
)
)
)
)
)
)
)
)
)
*
=
%
&
&
&
&
&
&
&
&
'
1
"x
$
E(x
t
)
"x
!
E(y
t
)
"y
!
&
2"
2
x
1
"
y
$
E(yt)
"
y
!
E(xt)
"
x
!
&
2"
2
y
1
"x"y
(
)
)
)
)
)
)
)
)
*
The S matrix is
E(x
t
) E(x
2
t
) E(y
t
) E(y
2
t
) E(x
t
y
t
)
S =
#
X
j="#
%
&
&
&
&
&
'
E(x
t
x
t"j
) E(x
t
x
2
t"j
) E(x
t
y
t"j
) E(x
t
y
2
t"j
) E(x
t
x
t"j
y
t"j
)
E(x
2
t
x
t"j
) E(x
2
t
x
t"j
) E(x
2
t
y
t"j
) E(x
2
t
y
2
t"j
) E(x
2
t
x
t"j
y
t"j
)
E(y
t
x
t"j
) E(y
t
x
t"j
) E(y
t
y
t"j
) E(y
t
y
2
t"j
) E(y
t
x
t"j
y
t"j
)
E(y
2
t
x
t"j
) E(y
2
t
x
t"j
) E(y
2
t
y
t"j
) E(y
2
t
y
2
t"j
) E(y
2
t
x
t"j
y
t"j
)
E(x
t
y
t
x
t"j
) E(x
t
y
t
x
t"j
) E(x
t
y
t
y
t"j
) E(x
t
y
t
y
2
t"j
) E(x
t
y
t
x
t"j
y
t"j
)
(
)
)
)
)
)
*
I must have seen a pretty way to simplify this when I wrote the problem, but I cant seem to see one now.
Still, its easy enough to compute.
2, 3. The general formula:
var(
") =
1
T
E(xx
0
)
"1
#
X
j="#
E((
t
x
t
x
0
t"j
(
t"j
)E(x
t
x
0
t
)
19
If you believe in homoskedasticity, then E((
t
x
t
x
0
t"j
(
t"j
) = E((
t
(
t"j
)E(x
t
x
0
t"j
) = %
2
$
$
j
E(x
t
x
0
t"j
). Then,
var(
") =
1
T
%
2
$
E(xx
0
)
"1
#
X
j="#
$
j
E(x
t
x
0
t"j
)E(x
t
x
0
t
)
In retrospect, 2 and 3 seem the same. I think I meant in 2 to correct for heteroskedasticity but not
autocorrelation, in which case the answer is
var(
") =
1
T
E(xx
0
)
"1
E((
2
t
x
t
x
0
t
)E(x
t
x
0
t
)
4. Under the null that the model is true, a good asset pricing model should have
1 = E
t
(m
t+1
R
t+1
) .
Thus, the errors, u
t+1
= m
t+1
R
t+1
! 1 should be unpredictable from anything z
t
at time t, including
z
t
= u
t"1
. Thus, E(u
t
u
t"j
) = 0. Yes, even if returns are predictable. The point of the asset pricing model
is that even if E(z
t
R
t+1
) 6= 0, discounted returns should not be forecastable, so E[z
t
(m
t+1
R
t+1
!1)] = 0,
including z
t
= u
t
. Its still true if the error is formed from an instrument or managed portfolio. If
f
t+1
= z
t
(m
t+1
R
t+1
!1), the model predicts E
t
(f
t+1
) = 0, so E(f
t
f
t+1
) = 0.
9 Problems for Chapter 12
1. The test assets can be risky return di!erences, but the market excess return must be relative to a risk
free rate proxy (which may be an estimated parameter). E(R
i
) !R
f
= "
i,m
E(R
m
) !R
f
implies
E(R
i
!R
j
) = "
i"j,m
E(R
m
!R
f
) but not E(R
i
!R
j
) = "
i"j,m"j
E(R
m
!R
j
R
e
f
0
E(R
e
)b
0
0 !I
K
#
where
f = f !E(f) and K is the number of factors. The estimates a
T
g
T
(b, E(f)) = 0 give the OLS
crosssectional regression for b, and the sample mean for E(f).
b =
C
0
C
"1
C
0
E
T
(R
e
) (1)
E(f) = E
T
(f).
20
where
C ) E(R
e
f
0
)
denotes the covariance matrix of returns and factors. (It is best to reserve d for the d matrix, and
the two are no longer equal.)
To nd the standard errors, just plug in to the general GMM formulas. The general formula (??) is
cov
E(f)
!
=
1
T
(ad)
"1
aSa
0
(ad)
"10
.
Filling in the pieces, the S matrix is
S =
#
X
j="#
E
"
u
t
u
0
t"j
u
t
f
0
t"j
f
t
u
0
t"j
f
t
f
0
t"j
#
u
t
) R
e
t
(1 !
f
0
t
b).
We can simplify S somewhat with the null hypothesis that pricing errors u
t
should not be forecastable
from t !j information,
S =
%
'
E(u
t
u
0
t
)
P
#
j=0
E
u
t
f
0
t+j
P
#
j=0
E
f
t+j
u
0
t
P
#
j="#
E
f
t
f
0
t"j
(
*
.
However, the factors need not be unpredictable, and may comove with the pricing errors, so no
further simplication is possible in general. The other terms are
ad =
"
!C
0
0
0 !I
K
# "
!C E(R
e
)b
0
0 !I
K
#
=
"
C
0
C !C
0
E(R
e
)b
0
0 I
K
#
(ad)
"1
=
"
(C
0
C)
"1
(C
0
C)
"1
C
0
E(R
e
)b
0
0 I
K
#
(ad)
"1
a = !
"
(C
0
C)
"1
C
0
(C
0
C)
"1
C
0
E(R
e
)b
0
0 I
K
#
.
Under the null, asymptotically, we will have E(R
e
) = C
0
b so we can simplify the formula now with
that substitution.
(ad)
"1
a = !
"
(C
0
C)
"1
C
0
bb
0
0 I
K
#
.
Were interested in the top left and bottom right elements of
1
T
(ad)
"1
a
"
S
11
S
12
S
21
S
22
#
a
0
(ad)
"10
.
The bottom right element is thus
var(E
T
(f)) =
1
T
S
22
.
This is the standard formula for the variance of the sample mean. The top left element is
var(
b) =
1
T
(C
0
C)
"1
C
0
S
11
C(C
0
C)
"1
+bb
0
S
22
bb
0
+ (C
0
C)
"1
C
0
S
12
bb
0
+bb
0
S
21
(C
0
C)
"1
C
0
21
This equation reminds us a great deal of the correction for crosssectional regressions of average
returns on betas. The rst term is the same standard error we derived ignoring sampling variation in
the sample mean, and looks like the usual formula for OLS regressions with standard errors corrected
for covariation. The remaining terms add the e!ects of the fact that the sample mean must be
estimated, as the extra terms in the Shanken formula correct for the fact that the betas had to be
estimated.
Next, we want to test the pricing errors. Use the genral formula,
Tcov
h
g
T
(
b)
i
=
I !d(ad)
"1
a
I !d(ad)
"1
a
0
.
We have (ad)
"1
a. Then
I !d(ad)
"1
a = I !
"
C !E(R
e
)b
0
0 I
K
# "
(C
0
C)
"1
C
0
bb
0
0 I
K
#
=
"
I !C(C
0
C)
"1
C
0
(E(R
e
) !Cb) b
0
0 0
#
Under the null, E(R
e
) !Cb = 0, so the top right term vanishes. Since the E(f) moment is zero in
every sample, the last K diagonal elements of cov(g
T
) are zero. The top left part, in which we are
interested, gives us
cov( ') =
1
T
I !C(C
0
C)
"1
C
0
S
11
I !C(C
0
C)
"1
C
0
Thus, the pricing error test statistic is not a!ected by the fact that the factor mean E(f) is estimated.
This is natural, since the E(f) moments are set to zero in each sample.
2. If we really want to distinguish factor models based on factor risk premia !, we can do it by using
single regression betas in the expected return  beta model. However, though the new ! are useful for
testing for the marginal importance of factors, they lose their interpretation as the expected returns
on factor mimicking portfolios.
To see this, dene "
s
ij
as the single regression coe$cient of return i on a constant and factor j alone.
"
s
ij
=
cov(r, f
j
)
var(f
j
)
.
The vector of such betas across all factors is
"
s
i
= diag
h
cov(
f,
f
0
)
i
"1
cov
r,
f
R
i
= '
h
1!cov(R
i
,
f
0
)
b
i
='
1!cov(R
i
,
f
0
)diag
h
cov(
f,
f
0
)
i
"1
diag
h
cov(
f,
f
0
)
i
='
h
1 !"
s0
i
diag
h
cov(
f, f
0
)
i
b
i
22
E(R
i
) = ' +"
s0
!
s
.
Now the factor risk premia are dened as
!
s
) !' diag
h
cov(
f, f
0
)
i
b
Now !
s
j
= 0 if and only if b
j
= 0, so a test on factor risk premia so dened is equivalent to a test
whether factor j is marginally important. Surprisingly, the !
s
s dened from single regression betas
deliver a multiple regression test for the importance of a factor given all the others!
However, single regression based !
s
do not have the interpretation as the price of the factors in the
interesting case that factors are correlated. A factor that is a return will have a single regression beta
of one on itself, but will also have nonzero single regression betas on the other (correlated) factors.
Therefore, the beta pricing model does not imply that the factor risk premium !
s
equals the expected
excess return of the factor.
11 Problems for Chapter 14
1. Adding pricing errors to the timeseries regression equation, we obtain
R
ei
t
= '
i
+"
0
i
! +"
0
i
[f
t
!E(f
t
)] +(
i
t
.
Stacking assets i = 1, 2, ...N to a vector
R
e
t
= ' +B! +B[f
t
!E(f
t
)] +(
t
where B denotes a N K matrix of regression coe$cients of the N assets on the K factors.
If we t this model, maximum likelihood will give assetby asset OLS estimates of the intercept
a = ' +B(! !E(f
t
)) and slope coe$cients B. It will not give separate estimates of ' and !. The
most that the regression can hope to estimate is one intercept; if one chooses a higher value of !,
we can obtain the same error term with a lower value of '. The likelihood surface is at over such
choices of ' and !. One could do an adhoc second stage, minimizing (say) the sum of squared '
to choose ! given B, E(f
t
) and a. This intuitively appealing procedure is exactly a crosssectional
regression. But it would be adhoc, not ML.
2. Instead of writing a regression, build up the ML for the CAPM a little more formally. Write the
statistical model as just the assumption that individual returns and the market return are jointly
normal,
"
R
e
R
em
#
*N
"
E(R
e
)
E(R
em
)
#
,
"
% cov(R
em
, R
e0
)
cov(R
em
, R
e
) %
2
m
#!
The models restriction is
E(R
e
) = #cov(R
em
, R
e
).
Estimate # and show that this is the same timeseries estimator as we derived by presupposing a
regression.
Answer: The likelihood function is
L = !
1
2
T
X
t=1
"
R
e
R
em
#
!
"
E(R
e
)
E(R
em
)
#!
0
"
% cov(R
em
, R
e0
)
cov(R
em
, R
e
) %
2
m
#
"1
"
R
e
R
em
#
!
"
E(R
e
)
E(R
em
)
#!
.
23
Imposing the model
E(R
e
) = #cov(R
em
, R
e
)
E(R
em
) = #%
2
m
the restricted likelihood function is
L = !
1
2
T
X
t=1
"
R
e
R
em
#
!#
"
cov(R
em
, R
e
).
%
2
m
#!
0
"
% cov(R
em
, R
e0
)
cov(R
em
, R
e
) %
2
m
#
"1
"
R
e
R
em
#
!#
"
cov(R
em
, R
e
)
%
2
m
#!
.
+L
+#
=
T
X
t=1
"
cov(R
em
, R
e
)
%
2
m
#
0
"
% cov(R
em
, R
e0
)
cov(R
em
, R
e
) %
2
m
#
"1
"
R
e
R
em
#
!#
"
cov(R
em
, R
e
)
%
2
m
#!
= 0.
"
cov(R
em
, R
e
)
%
2
m
#
0
"
% cov(R
em
, R
e0
)
cov(R
em
, R
e
) %
2
m
#
"1
"
E
T
(R
e
)
E
T
(R
em
)
#
!#
"
cov(R
em
, R
e
)
%
2
m
#!
= 0.
"
cov(R
em
, R
e
)
%
2
m
#
0
"
% cov(R
em
, R
e0
)
cov(R
em
, R
e
) %
2
m
#
"1
"
E
T
(R
e
)
E
T
(R
em
)
#
"
cov(R
em
, R
e
)
%
2
m
#"
% cov(R
em
, R
e0
)
cov(R
em
, R
e
) %
2
m
#
"1
"
cov(R
em
, R
e
)
%
2
m
#
= # = 0.
To make it easy, use only one test asset (you can use the partitioned matrix inverse formulas to do
the same thing with many test assets)
"
% cov(R
em
, R
e
)
cov(R
em
, R
e
) %
2
m
#
"1
=
"
%
2
m
!cov(R
em
, R
e
)
!cov(R
em
, R
e
) %
#
%%
2
m
!cov(R
em
, R
e
)
2
Then,
# =
"
cov(R
em
, R
e
)
%
2
m
#
0
"
%
2
m
!cov(R
em
, R
e
)
!cov(R
em
, R
e
) %
# "
E
T
(R
e
)
E
T
(R
em
)
#
"
cov(R
em
, R
e
)
%
2
m
# "
%
2
m
!cov(R
em
, R
e
)
!cov(R
em
, R
e
) %
#"
cov(R
em
, R
e
)
%
2
m
#
=
cov(R
em
, R
e
)%
2
m
E
T
(R
e
) !cov(R
em
, R
e
)
2
E
T
(R
em
) !%
2
m
cov(R
em
, R
e
)E
T
(R
e
) +%
2
m
%E
T
(R
em
)
%
2
m
(%%
2
m
!cov(R
em
, R
e
)cov(R
em
, R
e
))
=
!cov(R
em
, R
e
)
2
+%
2
m
%
(%%
2
m
!cov(R
em
, R
e
)
2
)
E
T
(R
em
)
%
2
m
=
E
T
(R
em
)
%
2
m
Look at the big picture: # is estimated from the market return alone,
E
T
(R
em
) = #%
2
m
completely ignoring the rest of the model
E(R
e
) = #cov(R
em
, R
e
)
This is the timeseries regression.
24
12 Problems for Chapter 17
1. You might want to exercise American puts early.
2. Retrace the steps in the integral derivation of the BlackScholes formula and show that the dw does
not a!ect the nal result.
A:
lnS
T
= lnS
0
+
!
%
2
2
!
T +%
(
T(
ln"
T
= ln"
0
!
r +
1
2
!r
%
2
+
1
2
%
2
w
!
T !
!r
%
(
T( !%
w
(
T&
C
0
=
Z
#
S
T
=X
Z
"
T
(()
"
t
S
T
(() df (() df(&) !
Z
#
S
T
=X
Z
"
T
(()
"
t
X df (() df(&).
C
0
=
Z
#
S
T
=X
Z
e
"
r+
1
2
(
"r
!
)
2
+
1
2
"
2
w
T"
"r
!
%
T$""w
%
T#
S
0
e
("
1
2
"
2
)T+"
%
T$
f (&) d&f(()d(
!X
Z
#
S
T
=X
e
"
r+
1
2
(
"r
!
)
2
+
1
2
"
2
w
T"
"r
!
%
T$""w
%
T#
f(&)d&f (() d(
= S
0
Z
#
S
T
=X
Z
e
"
1
2
"
2
w
T""w
%
T#
f(&)d&
e
h
"r"
1
2
"
2
+(
"r
!
)
2
i
T+(""
"r
!
)
%
T$
f(()d(
!X
Z
#
S
T
=X
Z
e
"
1
2
"
2
w
T""w
%
T#
f(&)d&
e
"
r+
1
2
(
"r
!
)
2
T"
"r
!
%
T$
f (()
We can bring the [] term out in front. Evaluating it,
Z
e
"
1
2
"
2
w
T""w
%
T#
f(&)d&
=
1
(
2)
Z
e
"
1
2
"
2
w
T""w
%
T#"
1
2
#
2
d&
1
(
2)
Z
e
"
1
2
(#+"
w
%
T)
2
d&
That is the integral under a normal distribution with mean %
w
(
T and standard deviation 1, which
is 1. Thus, we multiply both terms of the BlackScholes formula by 1, which does not change them.
3. From (17.2), express the BlackScholes discount factor as a function of the stock and bond price.
This expression shows that the BlackScholes model is equivalent to pricing an index option with the
CAPM.
Answer
d"
"
= !rdt !
( !r)
%
2
dS
S
!dt
=
( !r)
%
2
!r
dt !
( !r)
%
2
dS
S
ln"
t
!ln"
0
=
( !r)
%
2
!r
t !
( !r)
%
2
(lnS
t
!lnS
0
)
25
13 Problems for chapter 18
14 Problems for Chapter 19
15 Problems for Chapter 20
1. Go back to the derivation on p.399. We start with
p
t"1
!d
t"1
= const +
#
X
j=0
$
j
(#d
t+j
!r
t+j
)
Then, take E(I
t
) !E(I
t"1
) of both sides. As long as p
t
, d
t
and r
t
are in I
t
, we can conclude
0 = [E(I
t
) !E(I
t"1
)]
#
X
j=0
$
j
(#d
t+j
!r
t+j
)
and hence the identity
r
t
!E(r
t
I
t"1
) = #d
t
!E(#d
t
I
t"1
) + [E(I
t
) !E(I
t"1
)]
#
X
j=1
$
j
(#d
t+j
!r
t+j
) .
Hence,
(a) The equation can work for information sets that are coarser than agents, including the infor
mation set of a VAR. However,
(b) The results will depend on the information set you choose. Adding more variables to a VAR
can change the fraction of return variance attributed to the di!erent components.
2. (Fama and Bliss 1987) See the term structure chapter for notation.
The basic idea, is that there is a mechanical connection between the rst period holding period return
and the second period yield. The following picture considers what happens if the one year yield is
5% and the two year yield is 10%. As you can see, the expectations hypothesis expected returns
the same for the rst year mean that the one period yield must rise to 15% the next year. You can
also see that as we change the rst year holding period return, we mechanically change the second
year return (one year yield in second year). Move point A up and down.
26
0.05
0.10
0.15
0.20
lnP
Time
0 1
2
A
This holds for expected values as well as ex post values, or values forecast by a variables such as
the forward  spot spread the more goes to a change in yield y
(1)
t+1
!y
(1)
t
the less goes to a holding
period return hpr
(2)
t+1
.
Now, to express the same idea formally.
p
(2)
t
= !y
(1)
t+1
!hpr
(2)
t$t+1
thats cool in its own right. It says that the bond price is the discounted value of 1 dollar (ln(1) = 0),
discounted by the bonds returns. This should remind you of the Campbell Shiller identity that you
can discount a stock price by its expost returns. You can see that given prices at t, the change in
yield y
(1)
t+1
and the holding period return hpr
(2)
t$t+1
are mechanically linked. We want to say something
about forward rates, so lets get there
p
(1)
t
= !y
(1)
t
f
(1$2)
t
= p
(1)
t
!p
(2)
t
= !y
(1)
t
!p
(2)
t
f
(1$2)
t
= !y
(1)
t
+y
(1)
t+1
+hpr
(2)
t$t+1
f
(1$2)
t
!y
(1)
t
=
y
(1)
t+1
!y
(1)
t
hpr
(2)
t$t+1
!y
(1)
t
.
Aha! The left hand variable is the forwardspot spread in the Fama Bliss regression. The right hand
term is the change in one year yield, and the holding period return on two year bonds. Now run a
27
regression of both sides on the forwardspot spread. The left hand side is 1 forward spot on forward
spot. The right hand side gives the coe$cient b
1
in
y
(1)
t+1
!y
(1)
t
= a +b
1
f
(1$2)
t
!y
(1)
t
+(
t+1
and the coe$cient b
2
in
hpr
(2)
t$t+1
!y
(1)
t
= a
2
+b
2
f
(1$2)
t
!y
(1)
t
+(
t+1
Thus,
1 = b
1
+b
2
.
See Fama and Bliss (1987) for the general case longer maturities.
r
t
= #d
t
+$(p
t
!d
t
) !(p
t"1
!d
t"1
)
r
t
!E
t"1
(r
t
) = #d
t
!E
t"1
(#d
t
) +$ (E
t
!E
t"1
) (p
t
!d
t
)
r
t
!E
t"1
(r
t
) = #d
t
!E
t"1
(#d
t
) +$ (E
t
!E
t"1
)
#
X
j=1
$
j"1
(#d
t+j
!r
t+j
)
#d
t
!E
t"1
(#d
t
) + (E
t
!E
t"1
)
#
X
j=1
$
j
(#d
t+j
!r
t+j
)
3. Conceptually, what were doing is simple. Imagine simulating out a huge number of data points from
the VAR. Then, take only the return data, ignoring data on other variables. Run a regression of
returns on lagged returns. Were looking for that regression. Thats straightforward to do numerically
for a specic example. The algebra is hard, because were analytically deriving the result of this
operation. You just have to go through and do for prices what we did for returns. The case is
simple enough that you can follow the same procedure as in How to nd the univariate return
representation on p.418. (You dont have to follow the general procedure, constructing the spectral
density and factoring it.) The equation for prices is, from (20.19)
#p
t+1
= (1 !b)(d
t
!p
t
) +
(
dt+1
!
1
1 !$b
&
t+1
%
2
v
= a
2
%
x
+
1 +b
2
%
2
r
!2ab%
xr
E(y
t
y
t"1
) = !#%
2
v
= !b%
2
r
+a%
xr
1 +#
2
#
=
a
2
%
2
x
+
1 +b
2
%
2
r
!2ab%
xr
b%
2
r
!a%
xr
To generate uncorrelated returns, we need # = b
1 +b
2
b
=
a
2
%
2
x
+
1 +b
2
%
2
r
!2ab%
xr
b%
2
r
!a%
xr
solving for %
xr
1 +b
2
b
!
b%
2
r
!a%
xr
= a
2
%
2
x
+
1 +b
2
%
2
r
!2ab%
xr
1 +b
2
%
2
r
!a
1 +b
2
b
!
%
xr
= a
2
%
2
x
+
1 +b
2
%
2
r
!2ab%
xr
2ab%
xr
!a
1 +b
2
b
!
%
xr
= a
2
%
2
x
"
2b !
1 +b
2
b
!#
%
xr
= a%
2
x
30
b !
1
b
%
xr
= a%
2
x
Substituting %
xr
= $%
x
%
r
,
$ =
ab
(b
2
!1)
%
x
%
r
= !
ab
(1 +b)(1 !b)
%
x
%
r
As you see, you cannot get a zero correlation to do it. You need a negative correlation between
expected return and actual return shocks to generate uncorrelated returns.
5. First, the long run variance of a stationary series must be zero. The denition of covariance stationary
is that variances exist and variances and covariances are not functions of time. If a series is stationary,
variances exist, so
1
k
var(x
t+k
!x
t
) =
1
k
(var(x
t+k
) +var(x
t
) !2cov(x
t
, x
t+k
))
The covariance is bounded by the variance, so the whole thing goes to zero as k & $. If x has a
unit root, var(x) does not exist (innite) so you cant do the rst step of this.
Now, apply this logic to the stationary series x
t
!y
t
. and the same for y.
1
k
var [x
t+k
!y
t+k
!(x
t
!y
t
)]
=
1
k
var [(x
t+k
!x
t
) !(y
t+k
!y
t
))]
=
1
k
(var (x
t+k
!x
t
) +var (y
t+k
!y
t
) + 2cov [(x
t+k
!x
t
) , (y
t+k
!y
t
)])
Since each of x
t
and y
t
have unit roots, we know
lim
k$#
1
k
var(x
t+k
!x
t
) = v
x
> 0.
Thus, the only way for the above expression to go to zero is if the series are perfectly correlated in
the long run if v
x
= v
y
and cov [(x
t+k
!x
t
) , (y
t+k
!y
t
)] = % (x
t+k
!x
t
) % (y
t+k
!y
t
)
6.
dp
t+1
= bdp
t
+(
dp
t+1
r
t+1
= (1 !$b)dp
t
+(
rt+1
Its easiest to do all this sort of thing in vector form,
"
dp
t+1
r
t+1
#
=
"
b 0
(1 !$b) 0
#"
dp
t
r
t
#
+
"
(
dpt+1
(
rt+1
#
y
t+1
= Ay
t
+(
t+1
Then
y
t+2
= Ay
t+1
+(
t+2
= A
2
y
t
+(
t+2
+A(
t+1
y
t+3
= A
3
y
t
+(
t+3
+A(
t+2
+A
2
(
t+1
31
and the long horizon regression is
(y
t+1
+y
t+2
+y
t+3
+...y
t+N
) = (A+A
2
+..+A
N
)y
t
+((
t+N
+(I+A)(
t+N"1
+...+(I+A+..+A
N"1
)(
t+1
)
We can do the coe$cients analytically.
A =
"
b 0
(1 !$b) 0
#
A
2
=
"
b
2
0
(1 !$b) b 0
#
A
3
=
"
b
3
0
(1 !$b) b
2
0
#
A
j
=
"
b
j
0
(1 !$b) b
j
0
#
Thus, since
N
X
j=1
b
j
=
b !b
N
+ 1
1 !b
the long horizon return regression coe$cient is
r
t$t+N
=
b !b
N+1
1 !b
(1 !$b) dp
t
+e
r,t+k
As you can see, these rise close to linearly at rst, but eventually approach a limit
b
1 !b
(1 !$b) .
To do the R
2
we need to evaluate the error covariance matrix, the bottom right element of
%+ (I +A)%(I +A)
0
+ (I +A+A
2
)%((I +A+A
2
)
0
.
I didnt get anywhere with analytical manipulation of this. To see the R
2
rise with horizon, you have
to compute %
2
(x")/%
2
(() numerically using this formula. (See Hodrick 1992 for lots of calculations
like this.)
16 Problems for Chapter 21
1. Suppose habit accumulation is linear, and there is a constant riskfree rate or linear technology equal
to the discount rate, R
f
= 1/&. The consumers problem is then
max
#
X
t=0
&
t
(C
t
!X
t
)
1"!
1 !#
s.t.
X
t
&
t
C
t
=
X
t
&
t
e
t
+W
0
; X
t
= *
#
X
j=1
,
j
C
t"j
where e
t
is a stochastic endowment. In an internal habit specication, the consumer considers all the
e!ects that current consumption has on future utility through X
t+j
. In an external habit specica
tion, the consumer ignores such terms. Show that the two specications give identical asset pricing
32
predictions in this simple model, by showing that internalhabit marginal utility is proportional to
externalhabit marginal utility, state by state.
A: The rst order conditions are
MU
t
= E
t
[MU
t+1
]
where MU denotes marginal utility. In the external case, marginal utility is simply
MU
t
= (C
t
!X
t
)
"!
. (2)
In the internal case, marginal utility is
MU
t
= (C
t
!X
t
)
"!
!*
#
X
j=1
&
j
,
j
E
t
(C
t+j
!X
t+j
)
"!
(3)
The sum measures the habitforming e!ect of consumption. Now, guess the same solution as for the
external case,
(C
t
!X
t
)
"!
= E
t
h
(C
t+1
!X
t+1
)
"!
i
. (4)
and plug in to (3). We nd that the internal marginal utility is simply proportional to marginal
utility (2) in the external case,
MU
t
=
1 !
*&,
1 !&,
(C
t
!X
t
)
"!
. (5)
Since this expression satises the rst order condition MU
t
= E
t
MU
t+1
, we conrm the guess (4).
Ratios of marginal utility are the same, so allocations and asset prices are completely una!ected by
internal vs. external habit in this example.
2. Many models predict too much variation in the conditional mean discount factor, or too much
interest rate variation. This problem guides you through a simple example. Introduce a simple form
of external habit formation,
u = (C
t
!*C
t"1
)
1"!
and suppose consumption growth C
t+1
/C
t
is i.i.d. Show that there interest rates still vary despite
i.i.d. consumption growth.
A:
m
t+1
=
(C
t+1
!*C
t
)
"!
(C
t
!*C
t"1
)
"!
m
t+1
=
(C
t+1
/C
t
!*)
"!
(C
t
/C
t"1
!*)
"!
C
t
C
t"1
"!
E
t
(m
t+1
) = E
(C
t+1
/C
t
!*)
"!
C
t
C
t
!*C
t"1
"!
= E
"
C
t+1
C
t
!*
"!
#
1 !*
C
t"1
C
t
!
The rst term is constant, but the second varies as consumption varies.
33
17 Problems for the Appendix
1. Find the di!usion followed by the log price,
y = ln(p).
A: Applying Itos lemma,
dy =
1
p
dp !
1
2
dp
2
p
2
=
!
1
2
%
2
dt +%dz.
This is not
d(ln(p)) =
dp
p
.
You have to include the second order terms. It matters whether you specify
dp
p
= dt +%dz
or
d lnp = dt +%dz.
The two terms are not the same; you have to add or subtract 1/2%
2
to go from one to the other.
2. Find the di!usion followed by xy.
A: Usually, we write
d(xy) = xdy +ydx
But this expression comes from the usual rst order expansions. When x and y are di!usions, we have
to keep second order terms. Write f(x, y) = xy. +f/+x = y, +f/+y = x, +
2
f/dy
2
= 0, +
2
f/+x
2
= 0,
+
2
f/+y+x = 1, so
d(xy) = xdy +ydx +dydx.
We used this fact in expanding d("p).
3. Suppose y = f(x, t) Find the di!usion representaiton for y. (Follow the obvious multivariate extension
of Itos lemma.)
A: Recognizing ahead of time that terms dt
2
and dtdz will drop,
dy =
+f
+t
dt +
+f
+x
dx +
1
2
+
2
f
+x
2
dx
2
dy =
+f
+t
+
+f
+x
x
+
1
2
+
2
f
+x
2
%
2
x
!
dt +
+f
+x
%
x
dz
4. Suppose y = f(x, w), with both x, w di!usions. Find the di!usion representation for y. Denote the
correlation between dz
x
and dz
w
by $.
A: First do a second order expansion,
dy =
+f
+x
dx +
+f
+w
dw +
1
2
+
2
f
+x
2
dx
2
+
+
2
f
+w
2
dw
2
+ 2
+
2
f
+x+w
dxdw
!
Then, get rid of terms dt
2
and dzdt, and organize the result into dt and dz terms
dy =
+f
+x
x
+
+f
+w
w
+
1
2
+
2
f
+x
2
%
2
x
+
+
2
f
+w
2
%
2
w
+ 2
+
2
f
+x+w
%
x
%
w
$
!!
dt
+
+f
+x
%
x
dz
x
+
+f
+w
%
w
dz
w
34