Asset Pricing

Prof. Dr. Gunter Löffler

Winter 2018
Slides are only for the personal use of students of this course.
© Gunter Löffler 2018
General information

How to obtain slides, problem sets and other information

– moodle.uni-ulm.de
Exercises: approx. every two weeks (instead of lecture) according to schedule
on moodle
Questions: during class, after class, see us at office hours, send an e-mail
– Gunter Löffler: gunter.loeffler uni-ulm.de
– Nenad Ćurčić nenad.curcic uni-ulm.de

Asset Pricing 2
Course requirements and organization

You need some mathematics and statistics (we don’t do continuous

time analysis or GMM so it’s fair to say “some”)
You don’t need to have a background in finance but if you don’t have
such a background you surely benefit from the introductory chapters of
a book like Brealey/Myers/Allen: Principles of Corporate Finance or
Welch: Corporate Finance, which is available on:
https://www.afajof.org/page/HistoricalTextbooks
Study textbooks / articles as we move on
Carefully read papers to be discussed in class. Be ready to contribute
to class discussion.
Prepare problems to be discussed in class
Working with data on the computer is both fun and fosters
understanding of the material

Asset Pricing 3
Course outline

1. Introduction: finance basics

Some terminology and conventions, expected utility
2. The stochastic discount factor
Using the stochastic discount factor approach to understand returns on
risky and risk-free assets
3. Factor pricing models
The CAPM and the empirical evidence, multi-factor models
4. Aggregate stock price behavior
Equity premium puzzle
Time series predictability
5. Rationality and Behavioral Finance
Bubbles, Prospect Theory
Appendix

Asset Pricing 4
Literature

The following textbook has the biggest overlap with the course (but also
contains a lot of material not covered in this course):
Cochrane: Asset Pricing, 2005, in particular: chapters 1 (not 1.5), 9 (only
9.1), 12 (only 12.3), 20, 21 (21.1), Revised Edition.
1st edition will do but check out the typo list on Cochrane‘s homepage.
The reading list contains papers that will be discussed in class or serve as
a basis for problems
Other sources which also cover parts of the course:
– Campbell/Lo/MacKinlay: The Econometrics of Financial Markets.
– Lengwiler: Microfoundations of Financial Economics.
– Constantinides: Rational asset pricing, Journal of Finance 57, 2002,
1567-1591.
– Campbell: Asset pricing at the millenium, Journal of Finance 55, 2000,
1515-1567.
Suggestions for further reading
– Shiller, R.: Irrational Exuberance.
– Garber, P.: Famous First Bubbles.
– Lewis, M.: The Big Short.
Asset Pricing 5
Reading list

Cochrane: Asset Pricing (in particular: chapters 1 (not 1.5), 9 (only

9.1), 12 (only 12.3), 20, 21 (21.1)
Fama/French (1992): The cross-section of expected stock returns, Journal
of Finance 47, 427-465.
Fama/French (2015): A five-factor asset pricing model. Journal of Financial
Economics 116, 1-22.
Goyal/Welch (2003): Predicting the equity premium with dividend ratios,
Management Science 49, 639-654.
Brunnermeier/Nagel (2005): Arbitrage at its limits: Hedge funds and the
technology bubble, Journal of Finance 59, 2013-2040.
Fama (2014). Two pillars of asset pricing. American Economic Review 104,
1467-1485.
Thaler (2016). Behavioral economics: Past, present, and future. American
Economic Review, 106, 1577-1600.
Kahneman/Tversky (1979): Prospect theory: An analysis of decision under
risk. Econometrica 47, 263-291.

Asset Pricing 6
What asset pricing is about

Neo-classical asset pricing theory (rationality,

perfect and complete markets)

Market imperfections and

incompleteness,
irrationality...

consistent?
understand

Real world asset prices (stocks, bonds,

real estate,…)

Asset Pricing 7
An example of the issues we address: Understand the average
return on stocks

Questions we ask
What return on stocks can we reasonably expect over the long run?
What is the expected return on stocks over the next three years?

Why is this relevant?

You and me:
– Invest in stocks or in bonds?
– How much do I need to save for retirement?
Firms: Build a new factory or invest in stocks instead?
Governments: Invest in stocks for future generations?

Asset Pricing 8
Real value of a dollar invested at the end of 1925 (until 2017)

S&P 500 Small Cap Corporate Bonds Long T Bond T Bill

2182.8
1000
410.3

15.1
10
9.4

1.4

0,1
1926 1941 1956 1971 1986 2001 2016

Sources: http://www.hec.unil.ch/agoyal/
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Asset Pricing 9
Value of a dollar invested at the end of 1989

S&P 500 NASDAQ COMPOSITE

25

20

15

10

Source: Datastream
Asset Pricing 10
Course outline

1. Introduction: finance basics

Some terminology and conventions, expected utility
2. The stochastic discount factor
Using the stochastic discount factor approach to understand returns on
risky and risk-free assets
3. Factor pricing models
The CAPM and the empirical evidence, multi-factor models
4. Aggregate stock price behavior
Equity premium puzzle
Time series predictability
5. Rationality and Behavioral Finance
Bubbles, Prospect Theory

Asset Pricing 11
Payoffs and returns and the notation that we will use

price: p
payoff: dollar amount that an investment returns x
gross return: payoff relative to the investment R=x/p
net return: gross return - 1 r

Example: I buy a stock today at 100 and sell it one year later at 110.
=> The payoff is 110
=> the gross return is 110/100 = 1.1
=> the net return is 110/100 – 1 = (110-100)/100 = 10%

We will often say just return which can then mean gross or net.
As notation differs across papers, we won‘t always stick to the notation from
this slide.

Asset Pricing 12
Timing conventions

t-1 t t+1

Rt = Rt-1,t = return over period [t-1, t]

Rt,t+k = return over periods [t, t+k]
xt = payoff received in t
Length of period can be anything (one day, one week, one month, one year…)
In this class we usually set period length to one year or do not specify it at all
because it doesn’t matter for our purpose
We call a model with two dates (say t and t+1) a two-period model (think of t
being the end of the first period, t+1 the end of the second). We could also call
it a one-period model (think of t as the start of the period, t+1 its end)

Asset Pricing 13
Timing conventions – special cases

We usually work with end-of-period prices. Talking about the stock price in
year t, we usually think about the stock price from the end of December of year
t. For a flow variable such as consumption, conventions are less clear cut.
We can think of consumption data as measuring consumption at the end of the
year. An annual growth rate for year t would then be ct/ct-1 - 1. But one can also
think of consumption data as measuring consumption at the start of the year.
The annual growth rate for year t would then be ct+1/ct - 1

The risk-free asset is not only special in terms of risk but also in terms of the
timing convention. Why? The one-period interest rate that the risk-free asset
offers at time t is the same as the return that it offers from t to t+1.
This is why there‘s two common conventions. Sometimes Rtf refers to the
return that can be earned from t-1 to t, similar to the convention for risky
assets. Sometimes Rtf refers to the rate at time t, and thus to the return that
can be earned from t to t+1. It’s mostly obvious which convention is used.

Asset Pricing 14
A note on notation

Ideally, these slides would be consistent with respect to notation but neither
Cochrane’s book nor the literature is.
My response was to be consistent with the main literature that a chapter builds on.

That means, for example:

 can denote the subjective discount factor or the risk measure beta.
the return of asset i is written as Ri or Ri

Asset Pricing 15
Compounding and log returns

If we invest over T periods from t=0 to t=T we have

R0,T = R1R2R3 … RT = (1+r1) (1+r2) (1+r3) … (1+rT)
If the return is R in each period we have R0,T = RT
It is often convenient to work with logarithmic returns: lnRt =ln(Rt)
lnR0,T = lnR1 + lnR2 + lnR3 + ... + lnRT
If the returns are the same for each period we have

lnR0,T = lnR·T
RT = exp(lnR·T)

R is usually called simple, or Dollar, or discrete return

lnR is usually called log return, or continously compounded return

Asset Pricing 16
Real rates of return

Real return: Investors should care about inflation because it reduces

the purchasing power of future payoffs. Therefore one often computes
real returns.
One mostly uses a consumer price index CPI. The inflation rate in t is
CPIt / CPIt-1 − 1.
Real return is defined as
xt / CPI t xt / pt 1 Rt (nominal )
Rt (real ) = = =
pt 1 / CPI t 1 CPI t / CPI t 1 CPI t / CPI t 1

Asset Pricing 17
Happiness / utility

By utility is meant that property in any object, whereby it tends to produce

benefit, advantage, pleasure, good, or happiness, (all this in the present
case comes to the same thing) or (what comes again to the same thing)
to prevent the happening of mischief, pain, evil, or unhappiness to the
party whose interest is considered.
J. Bentham, 1780

The object of Economics is to maximise happiness by purchasing

pleasure, as it were, at the lowest cost of pain.

W. Jevons, 1871

Let there be granted to the science of pleasure what is granted to the

science of energy; to imagine an ideally perfect instrument, a
psychophysical machine, continually registering the height of pleasure.

F. Edgeworth, 1881
Asset Pricing 18
Modeling choice behavior: utility functions

Say you have 4 Euro

You think about spending them on Bounty and/or Mars bars
(price is 1 Euro each)
In finance and economics, we’d describe this problem as the maximization
of a utility function u
u (B, M)  max s.t. B × 1 Euro + M × 1 Euro <= 4 Euro
where B and M is the number of Bounties or Mars that you buy,
respectively
The restriction that we cannot spend more than we have is called the
budget constraint
A utility function could be u = B0.5 + M0.25 . The optimal choice would then
be B = 3 and M = 1

Note: This example is simplified because we assume that we only derive utility from
Bounty or Mars. But in real life there is other consumption that matters which is why we
should consider u(other consumption, B, M)
Asset Pricing 19
Modeling choice behavior under uncertainty: expected utility
maximization

Again, u(c) describes how much utility you derive from consuming c
But now c is not certain. Say because it is next year’s consumption and we
don’t know how much we will earn next year
Under certain conditions, it is possible to show theoretically that one can
describe human behavior as if people maximize expected utility

E[u(c)]  max
Note that maximizing E[a + b∙u(c)] with a and b constant and b>0 is
equivalent to maximizing E[u(c)].

Asset Pricing 20
The most widely used utility function in asset pricing is power
utility: (c1- - 1)/(1-),  > 1

Mostly written as c1-/(1-), which is equivalent in terms of the resulting

choice behavior
The function takes negative values but this does not pose a problem (just
read it as: “-2 is better than -3”)
The function is not defined for c = 0 but this need not pose a problem (a
person with c = 0 can’t survive, so it does not make much sense to
compute utility)
The function is increasing: more is better
The function is concave: declining marginal value of having more. This
leads to risk aversion
The function has constant relative risk aversion: the level of wealth doesn’t
affect the percentage of your wealth you put at risk
The limit as  approaches 1 is equivalent to ln(c). To show this, start with
(c1--1)/(1-)

Asset Pricing 21
Concavity of u implies risk aversion

(Strict) concavity of u implies that it is better to have the average

consumption for sure than to have the uncertain consumption
=> in a formula: E[u(c)] < u[E(c)]
We call someone with such preferences risk averse
Illustration: consumption is either c1 or c2, each with prob = 0.5

u[E(c)]
u(c)
E[u(c)]

c
c1 E(c)
Asset Pricing 22
Measuring risk aversion – relative risk aversion

The coefficient of relative risk aversion is defined as:

u" (c )
RRA(c) = c
u'(c)

Interpretation: What is the relative change in u’(c) for a small relative change
of c?
du' (c ) / u' (c) u' ' (c)
RRA(c) =  = c
dc / c u' (c)

Properties of RRA(c):
 The higher RRA(c), the higher the risk aversion
 Risk aversion is measured locally for a consumption of c
 RRA(c) is appropriate for measuring preferences in situations of the type:
Either lose 10% of your wealth or gain 12% of your wealth.
Asset Pricing 23
An illustration of constant relative risk aversion with expected
utility function c1-/(1-)

A person has X (Euro) and two choices:

– Consume the money right away
– Participate in a gamble and consume the payoff. The payoff is zero
with probability p and twice the stake with probability 1-p.
Choice variable is percentage of X invested in gamble   [0,1]
Problem is thus to maximize

E (u ) = p ( X  X )1 /(1   )  (1  p)( X  X )1 /(1   )

It follows:

E (u ) = { p (1   )1 /(1   )  (1  p )(1   )1 /(1   )} X 1

… so X doesn’t matter
for choosing  to max E[u]

Asset Pricing 24
Application: utility of an insurance

 Quentin has a monthly income of 100. Quentin has a logarithmic utility

function. Each month, Quentin faces the risk of losing 19 with probability
50%.
 What is the maximum that Quentin would pay each month for an
insurance that completely eliminates the risk of losing 19?
 We compare the expected utility in the two situations, with z denoting the
price of insurance.
a) Buy insurance
E[u(c)] = ln(100-z)
b) Don’t buy insurance:
E[u(c)] = 0.5 ln(100-19) + 0.5·ln(100) = ln(810.5) + ln(1000.5) = ln(90)

 Both should be the same to get the maximum z, so

ln(100-z) = ln(90) => z=10

Asset Pricing 25
Course outline

1. Introduction: finance basics

Some terminology and conventions, expected utility
2. The stochastic discount factor
Using the stochastic discount factor approach to understand returns on
risky and risk-free assets
3. Factor pricing models
The CAPM and the empirical evidence, multi-factor models
4. Aggregate stock price behavior
Equity premium puzzle
Time series predictability
5. Rationality and Behavioral Finance
Inflation illusion, bubbles, Prospect Theory

Asset Pricing 26
Utility maximization and prices in a two-period economy

 is subjective discount factor

Consumption levels if none of the asset is bought et, et+1
Asset with price pt today pays off xt+1 tomorrow
a is amount of asset purchased
Problem: max u(ct) +  Et[u(ct+1)] s.t. ct = et - apt, ct+1 = et+1 + axt+1
=> first order condition

pt u’(ct) = Et [ u’(ct+1) xt+1 ]

Note: What we have in mind is real prices and payoffs

Asset Pricing 27
The stochastic discount factor

 u ' (ct 1 ) 
pt u’(ct) = Et [ u’(ct+1) xt+1 ] => pt = Et   xt  1 
 u ' (ct ) 

u ' (ct 1 )
We define mt+1=  and call it stochastic discount factor
u ' (ct )

pt = Et[mt+1 xt+1]

Asset Pricing 28
The stochastic discount factor vs. discount factors in classical
finance analysis

 xt 1   1  Et ( xt 1 )
pt = Et[mt+1 xt+1] pt = Et   = Et  xt 1  =
1  r  1  r  1 r

m is stochastic r is typically assumed to be known

m is the same for all r differs across assets

assets

Derivation based on Derivation based on identities and

optimization assumption of non-stochastic discount
factor

Asset Pricing 29
Deriving discount factors in the `classical´ way

Start with an identity, the definition of a return:

xt
Rt = (1  rt ) =
pt 1
Now shift dates one period into the future and take expectations:

 xt 1 
Et (1  rt 1 ) = Et  
p
 t 

Assume that the expected return is known to be a constant r and rearrange:

E t ( x t 1 ) x 
pt = = E t  t 1 
1 r 1  r 

The derivation shows that discount rates r are the same as expected returns.

Asset Pricing 30
Classical discount factors can still be useful, e.g. as a workhorse
for quick assessments or illustrations

Consider a stock as an asset that offers a stream of dividends plus the price
you fetch for it at the end of times, further assume that

Et p t  i 
lim
i  i
= 0 then:
(1 r )

  d t i 
pt = Et  i
 i =1 (1  r ) 
Now assume that dividends grow at an expected rate g, meaning
Et [dt+i] = dt (1+g)i

We then get
  d t  i   Et [d t  i ]  d t (1  g ) i d t (1  g ) [ ]
pt = Et   i
= i
= i
= =
 i =1 (1  r )  i =1 (1  r ) i =1 (1  r ) rg −

The formula is called Gordon growth formula and is great for quick back-of-
the-envelope calculations
Asset Pricing 31
Clarifying the difference between asset pricing and valuation

Several approaches for  cashflowt 

determining prices
Value = E  
 t =1 (1  discount ratet )t



Asset pricing Valuation

Understand what drives
prices: cash flows or
discount rates
Develop models for
discount rates
Compare model prices /
discount rates to observed
prices / returns
Predict payoffs (usually
called „cash flows“ in firm
valuation)
Get an estimate of
appropriate discount rates
(from asset pricing)
Derive an estimate of value

Asset Pricing 32
Understanding the risk-free rate of return Rf = xt+1/pt where xt+1 is
known with certainty

Use pt = Et[mt+1 xt+1] and definition of Rf to get Rf = 1/E[m]

Take logs of Rf = 1/E[m], assume consumption growth is lognormally
distributed, assume power utility, denote rf = lnRf, to get

2
rt f =  ln(  )   Et  ln ct 1   s t2 ( ln ct 1 )
2

Asset Pricing 33
The higher the covariance with consumption, the lower the price

Using cov(m,x) = E(mx) – E(m)E(x) and Rf = 1/E[m] we obtain

E ( x) E ( x ) cov u ' ( ct 1 ), xt 1 
p= f
 cov(m, x ) = f

R R u ' ( ct )

Another way of putting it: consider asset i with price 1 and

xt+1 = Ri => 1 = E(m)E(Ri) + cov(m,Ri)

E (R i )  R f = R f cov(m, R i )

Asset Pricing 34
Pricing with betas

We can write the previous result as

i 2
i f  cov( m , R )   s (m) 
E ( R )  R =  2
    =  i ,m lm
 s (m)   E (m) 

Asset Pricing 35
Mean-variance frontier

Using 1 = E(mRi) obtain 1 = E(m)E(Ri) + m,Ris(m)s(Ri) and thus

E(Ri)-Rf = – m,Ri s(m)s(Ri)/E(m)

Since -1 m,Ri  1:

s (m )
i f
E (R )  R 
E (m )
 
s Ri

Asset Pricing 36
Understanding the return on a risky asset

The basic equation with power utility and price = 1 again:

  c   
1 = Et    t 1  Rt 1 
  ct  
 

Now assume multivariate log-normality and take logs:

1
0 = ln[  ]  E [ln Rt 1 ]  E [  ln ct 1 ]  s 2 [ln Rt 1 ]   2s 2 [  ln ct 1 ]  2s [  ln ct 1 , ln Rt 1 ]
2
For the risk-free rate we obtain:
1
ln Rtf =  ln[  ]  E [  ln ct 1 ]   2s 2 [  ln ct 1 ]
2
For the excess return of a risky asset over the risk-free we obtain:
s 2 [ln Rt 1 ]

E ln Rt 1  ln Rt f
 2
= s [  ln ct 1 , ln Rt 1 ]

Asset Pricing 37
From two periods to infinite horizon and back


Investor maximizes Et   j u (ct  j )
j=0

Let pt be the price of a payoff stream xt+j and obtain


pt = Et  mt ,t  j xt  j
j =1

Since the equation holds in t+1 for xt+1+j we can reduce it to a two-period
version pt = Et[mt+1 (pt+1+ xt+1) ]

Asset Pricing 38
 From two periods to infinite horizon and back (explained)
 

Investor maximizes Et  j
u (ct  j )  max u (et  apt )  Et   j u (et  j  axt  j )
j =1
j =0

FOC:  pt u ' (ct )  Et   j u ' (ct  j ) xt  j = 0
j =1

In t we get: 
j
u ' (ct  j ) 
pt = Et   xt  j = Et  mt ,t  j xt  j
j =1 u ' (ct ) j =1


Likewise in t+1: pt 1 = Et 1  mt 1,t  j xt  j
j =2

   
The two together give:* pt = Et mt ,t  j xt  j =Et mt ,t 1 xt 1 
 mt ,t  j xt  j  
j =1  j =2 
= Et [mt ,t 1 xt 1  mt ,t 1 pt 1] = Et [mt ,t 1(pt 1  xt 1 )]

*Note: Et[Et+1(mt+1,t+jxt+1,t+j)] = Et[mt+1,t+jxt+1,t+j] through law of iterated expectations

Asset Pricing 39
mt,t+1mt+1,t+j = mt,t+j through definition of stochastic discount factor
Stochastic discount factor and the law of one price (LOP)

Law of one price: p(ax1+bx2) = ap(x1)+bp(x2)

Stochastic discount factor and law of one price:

Let y=ax1+bx2 then p(y) = E(my) = E(m(ax1+bx2)) = ap(x1)+bp(x2)

An (apparent) empirical violation of the law of one price is the closed-end

fund discount

Asset Pricing 40
Closed-end funds and net asset value

Closed-end funds are investment companies. They sell a fixed number of

shares at one time and invest the proceeds in other companies. After that
the shares trade on an exchange such as the NYSE
The investment portfolios of closed-end funds are managed by separate
entities known as investment advisers
The net asset value or NAV of an investment company is the company’s
total assets minus its obligations. For a closed-end fund investing in equity
shares of other companies, the assets would be those shares; obligations
include loans (if any), unpaid bills and provisions for expenses. The NAV is
more or less the value that you would get from liquidating the fund and
paying the proceeds to the shareholders
Typically, the market price of a closed-end fund share diverges from its net
asset value. If the market price is lower, there is a closed-end fund discount
and we would have p(ax1+bx2) < ap(x1)+bp(x2)
(An open-end fund issues new shares upon request, and buys them back
upon request - both at the NAV determined by the fund company)

Asset Pricing 41
Stochastic discount factor and absence of arbitrage

Absence of arbitrage: positive payoff implies positive price

if x  0 and x > 0 with positive probability then p(x) > 0

Stochastic discount factor and no arbitrage:

from definition of m, we follow m > 0 (positive marginal utility)
=> m > 0, x  0 with some states x > 0. Thus mx > 0 in some states and
else mx = 0 => E(mx) > 0

(Apparent) empirical violations of no arbitrage:

– existence of arbitrageurs
– violations of law of one price

Asset Pricing 42
Market efficiency

Common definitions of market efficiency

– The market fully and correctly reflects all relevant information in
determining asset prices
– If the market is efficient with respect to an information set, one cannot
make abnormal profits by trading on the basis of that information set
Sometimes classified according to type of information:
– Weak form (efficient w.r.t. historical prices and returns)
– Semi-strong form (efficient w.r.t. publicly available information)
– Strong form (efficient w.r.t. all information, incl. private one)
Why should markets be efficient? - competition.
In deriving the results of this chapter we have not assumed that markets
are efficient, but results can help us to test whether they are: You need an
asset pricing model to check efficiency, otherwise we cannot say whether it
“fully and correctly” reflects information or whether profits are “abnormal”

Asset Pricing 43
 Course road map: Where do we go from p = E(mx)?
Chapter

What matters for the price of an individual asset is covariance with the
discount factor. We examine the CAPM, a model that makes this
E ( xi ) relationship more tractable by making additional assumptions. 3
pi = f
 cov(m, xi )
R Empirical questions: Do stocks with higher covariance have higher
returns?

s (m ) There are bounds on the expected return of assets.

i
E (R )  R  f
E (m )
 
sR i
Empirical questions: Does the return on the aggregate stock 4
market lie within the bounds?

 u ' (c t  1 )  Prices can change as expectations change or utility functions

pt = Et   xt  1  change. 4
 u ' (ct )  Empirical questions: How do we account for the fact that stock
market returns seem to be predictable?

We explore departures from rational asset pricing

RATIONALITY People are not well characterized by standard expected utility
theory => Behavioral Finance 5
Empirical questions: How can we account for bubbles?

Asset Pricing 44
Course outline

1. Introduction: finance basics

Some terminology and conventions, expected utility
2. The stochastic discount factor
Using the stochastic discount factor approach to understand returns on
risky and risk-free assets
3. Factor pricing models
The CAPM and the empirical evidence, multi-factor models
4. Aggregate stock price behavior
Equity premium puzzle
Time series predictability
5. Rationality and Behavioral Finance
Bubbles, Prospect Theory

Asset Pricing 45
Deriving the CAPM in a two-period world with multivariate
normally distributed returns and exponential utility U(c) = -e-c

It follows from assumptions that:

E ( c )  ( 2 / 2 )s 2 ( c )
E (u ( c )) = e
The risk-free rate pays Rf, set of risky assets pays R (vector). Let yf be the
amount of wealth W put in the risk-free asset; y the vector with amounts
put in risky assets. The budget constraints are:
c = y f R f  y' R W = y f  y '1
Plug first constraint in utility function to obtain:
E ( u ( c )) =  e  
  y f R f  y ' E ( R )  (  2 / 2 ) y ' y

First-order condition (Rf denotes the vector 1Rf):

1 E ( R)  R f
y=

Which gives E ( R )  R f =  y
Then further assume that investors are identical. This implies that the
composition of the risky portfolio will be the one of the market portfolio.
Asset Pricing 46
The Capital Asset Pricing Model (CAPM)

The expected return on an asset is the risk-free rate plus beta times the
expected excess return on the market portfolio, the portfolio containing all
risky assets

E ( R i ) = R f   i , R m [ E ( R m  R f )]

Equivalent formulation

mt 1 = a  bRtm1

Asset Pricing 47
Some remarks on the CAPM (1)

Who developed the CAPM? Sharpe (1964), Lintner (1965) and Black (1972)

Why is it called a mean-variance model? - Assumptions are chosen such

that preferences over return and risk can be fully described through
preferences over mean and variance of portfolio returns

What is the market portfolio? – The portfolio containing all risky assets,
weighted by their market values

What are the central implications of the CAPM

– The market portfolio is mean-variance efficient
– The security market line: E[Ri] = Rf + i,RmE[Rm-Rf]

Asset Pricing 48
Some remarks on the CAPM (2)

Why mean-variance efficiency of the market portfolio?

– Investors will hold the market portfolio, but they wouldn’t want to hold
something inefficient
– We can replace the stochastic discount factor in the general pricing
equation with a portfolio that is perfectly correlated with the stochastic
discount factor. But perfect (negative) correlation implies mean-variance
efficiency

Why is it called a factor model? – In such a model, the stochastic discount

factor is replaced with a linear model mt+1=a+b’ft+1, where ft+1 is a vector of
factors. Factors are realizations of portfolio returns or other observable
variables.

Asset Pricing 49
Some problems when testing the CAPM

We do not observe the market portfolio without error

– Proxies: broad stock market indices (some studies include bonds and
other assets)

We do not observe betas without error

– Proxies: betas estimated with historical data (often grouping is used to
reduce estimation error)

We do not observe expected returns

– examine relation with realized returns

Asset Pricing 50
Testing the CAPM: Fama/MacBeth procedure for estimating the
CAPM

Estimate individual stock betas with time series regression

At each point in time, run cross-sectional regression with excess returns re

rite =  it lt   it , i = 1, 2,..., N
T T
1 ˆ , ˆ = 1
Estimate l and : lˆ =  l t i  ˆ it
T t =1 T t =1

Determine standard errors via

T T
1 1
s ( lˆ ) = 2
2
 ( lˆt  lˆ ) , s (ˆ i ) = 2
2 2
 (ˆ it  ˆ i ) 2
T t =1 T t =1

Then test
- significance of l̂ with a t-test: t = lˆ / s ( lˆ ) => “Does the factor matter for
pricing?”
- or that i are jointly zero (e.g. with the GRS test of Gibbons, Ross, and
Shanken (1989)) => Does the model fully explain average return
differences? Asset Pricing 51
Some more details on Fama/MacBeth

 The it in the Fama/MacBeth equation is not a constant that is going to be

estimated, but the error term in the regression. That is, we estimate a
regression without a constant.

rite =  it lt   it , i = 1,2,..., N

 Normally, one uses  to denote a constant, so why does Cochrane (and

following him, myself) use it for error terms? Well, if you average the
estimated it for one i over time, you get the average residual for firm i.
This average is similar to the constant that you would get in a time-series
regression using only observations for firm i.

Asset Pricing 52
Another procedure for testing implications of the CAPM

1. Find a characteristic that is associated with average returns. Sort

stocks into portfolios based on the characteristic
2. Compute betas for the portfolios, and check whether average return
spread is accounted for the spread in betas
3. If not, this indicates a violation of the CAPM

Or:
Sort stocks into portfolios based on a characteristic and analyze as
before. Then also check whether returns within these portfolios vary
with beta. This helps to assess whether it is the characteristic or the
beta that drives returns
If you haven‘t already done so, it‘s now a
good time to read Fama/French (1992): The
cross-section of expected stock returns,
Journal of Finance 47, 427-465.
Asset Pricing 53
 Some results from Fama/French (1992) based on US data from
1963-1990

BE/ME-sorted portfolios BE/ME-sorted portfolios

avg. monthly return (%)

2,5 2,5
2 2
1,5 1,5
1 1
0,5 0,5
0 0
0,0 0,5 1,0 1,5 2,0 2,5 3,0 0,75 1 1,25 1,5
BE/ME Beta

Asset Pricing 54
Some results from Fama/French (1992) based on US data from
1963-1990

Size-sorted portfolios Beta-sorted within largest size

1,6
avg. monthly return (%)

1,4
1,2
1
0,8
0,6
0,4
0,2
0
0 0,5 1 1,5 2
Beta

Asset Pricing 55
From the CAPM to multifactor models

CAPM is a one-factor model but empirical evidence suggests that one factor
is not enough
Theoretical foundations for multifactor models:
ICAPM (Intertemporal CAPM)
- multi-period analysis
- allow changes in investment opportunities
=> more than one factor needed (intuition: pay higher price for assets that do
well if investment opportunities deteriorate)

K
APT (Arbitrage Pricing Theory) e
ri =   ij f j   i
- start with statistical analysis j =1
- if var(i) -> 0 apply law of one price => price assets with factors
Extending the CAPM (1): Fama-French three-factor model

A successful and widely-used model for explaining average returns uses

three factors
– market return (rm)
– return on small minus big (SMB) portfolio
– return on high minus low book-to-market (HML) portfolio
Rational story for the model
– HML captures distress premium (value stocks do badly in times of
recession, financial stress) not captured by beta
– by construction, SMB and HML can capture unknown risk premia
that we fail to pick up with the CAPM. Differences in risk premia lead
to differences in today’s prices, and these influence SMB and HML.
If you haven‘t already done so, it‘s now a
good time to read Fama/French (2015): A
five-factor asset pricing model. Journal of
Financial Economics 116, 1-22.
Asset Pricing 57
Return analysis with a factor model

We run a time-series regression with the dependent variable being the

risk premium of an asset, a strategy or a fund i (general formula and
then the 3-Factor model):
K
rit  rft =  i    ij f tj  uit , t = 1,..., T
j =1

rit  rft =  i   i1 rmt  rft    i 2 SMBt   i 3 HMLt  uit , t = 1,..., T

If the alpha is significant we conclude
– That there is a return component not explained by the factors
– That there is abnormal performance

As a fund manager
– you’d like to have a positive and significant alpha
– Having just high average returns is not enough because you may
have generated them by having a high beta or a tilt to small and
high book-to-market stocks
Asset Pricing 58
An alternative to return analysis with a factor model:
characteristics-matched benchmarks

Idea: To figure out whether a portfolio has an abnormally high or low

return, compare it to the return of a portfolio that is similar in relevant
characteristics
Candidate for characteristics: the usual suspects such as size or
book-to-market
Commonly used way of constructing a characteristics-matched
benchmark: multiple sorts. Example for size and book-to-market: First
sort stocks into five portfolios according to size. Then sort each of
these into five portfolios according to book-to-market => 25 portfolios
defined trough intervals of size and book-to-market.
Then look up the portfolio whose characteristic (here: size and book-
to-market) intervals include the characteristic values of the portfolio
that you study. The former is then the “characteristics-matched
benchmark portfolio”. Or more specifically, for example, the “size and
book-to-market matched portfolio”
Then analyze: portfolio return minus characteristics-matched
benchmark portfolio returns.
Asset Pricing 59
Fama-French 3 factors: some questions

The premium on small stocks has been…

– ...
The premium on growth stocks has been…
– ...
In a regression analysis of a large stock’s return, the coefficient on
SMB will be ...
– ...
The fact that beta does not suffice to explain returns means that
rational asset pricing models have failed
 true  false
All investors believing in rational asset pricing should hold small
stocks and value stocks in order to earn higher returns
 true  false
To test whether the Fama-French 3 factor model works one tests
whether the coefficients on SMB and HML are significant
 true  false

Asset Pricing 60
Momentum and reversal: strategies based on past performance

Buying long-term (1-5 years) losers and selling long-term winners is

profitable (return reversal, contrarian strategy)
– can be explained with value effect

Buying short to mid-term (1-12 months) winners and selling short to mid-
term losers is profitable (momentum)
– cannot be explained with Fama-French three-factors

Asset Pricing 61
Momentum is different

Consider a stock that has experienced low returns in the past. Price today
is therefore relatively low and:
– BM is relatively high (would imply high expected returns)
– Size is relatively small (would imply high expected returns)
– Stock is likely to belong to long-term losers (would imply high expected
returns)
– Stock is likely to belong to short-term losers (would imply low expected
returns)

Note the difference. If price is low because of some risk, BM, SIZE and
reversal are likely to predict the risk premium in some way. Momentum will
not pick it up as it makes the opposite prediction.

Asset Pricing 62
Extending the CAPM (2): Carhart four-factor model and Fama-
French five-factor model

Based on empirical findings on momentum, Carhart (1997) suggests a four-

factor model:

rit  rft =    i1 rmt  rft    i 2 SMBt   i 3 HMLt   i 4WMLt  uit

where WML is the return on a winner minus loser portfolio, with winners
(losers) being stocks that performed best (worst) in previous periods.
Based on empirical findings as well as implied ceteris paribus relationships
between expected returns and current characteristics, Fama and French
(2015) suggest a five-factor model

rit  rft =    i1 rmt  rft    i 2 SMBt   i 3 HMLt

  i 4 RMWt   i 5CMAt  uit
where RMW is the return on a robust minus weak profitability portfolio and
CMA is the return on a conservative minus aggressive investment portfolio.

Asset Pricing 63
Value/growth and momentum continues to be high on the
research agenda: Examples of recent papers

Kapadia, Nishad. "Tracking down distress risk." Journal of Financial Economics

102.1 (2011): 167-182.
“This paper shows that exposure to aggregate distress risk is the underlying source of the
premiums for the Fama-French size (SMB) and value (HML) factors. Using a unique data
set of aggregate business failures of both private and public firms from 1926 to 1997 …
Both HML and SMB predict changes in future failure rates. Small stocks have lower
returns than large stocks and value stocks have lower returns than growth stocks when
the market expects an increase in future failure rates expected returns.”
Vayanos, Dimitri, and Paul Woolley. "An institutional theory of momentum and
reversal." Review of Financial Studies 26.5 (2013): 1087-1145.
“Our explanation of momentum and reversal is as follows. Suppose that a negative shock
hits the fundamental value of some assets. Investment funds holding these assets realize
low returns, triggering outflows by investors who update negatively about the efficiency of
the managers running these funds. As a consequence of the outflows, funds sell assets
they own, and this further depresses the prices of the assets hit by the original shock.
Momentum arises if the outflows are gradual, and if they trigger a gradual price decline
and a drop in expected returns. Reversal arises because outflows push prices below
fundamental values, and so expected returns eventually rise. Gradual outflows can be the
consequence of investor inertia or institutional constraints (…)”
Asset Pricing 64
Course outline

1. Introduction: finance basics

Some terminology and conventions, expected utility
2. The stochastic discount factor
Using the stochastic discount factor approach to understand returns on
risky and risk-free assets
3. Factor pricing models
The CAPM and the empirical evidence, multi-factor models
4. Aggregate stock price behavior
Equity premium puzzle
Time series predictability
5. Rationality and Behavioral Finance
Bubbles, Prospect Theory

Asset Pricing 65
The equity premium puzzle: the basic equation is one we have
already looked at

The basic equation with power utility and price = 1 again:

  c   
t  1
1 = Et     Rt 1 
  ct  
 

Now assume multivariate log-normality and take logs:

0 = ln[  ]  Et [ln Rt 1 ]  E [  ln ct 1 ] 
2

1 2

s [ln Rt 1 ]   2s 2 [  ln ct 1 ]  2s [  ln ct 1,ln Rt 1 ]

For the risk-free rate we obtain:

1
ln Rtf =  ln[  ]  E [  ln ct 1 ]   2s 2 [  ln ct 1 ]
2

For the excess return of a risky asset over the risk-free we obtain:
s 2 [ln Rt 1 ]
E ln Rt 1  ln Rt  
f
= s [  ln ct 1 , ln Rt 1 ]
2
Asset Pricing 66
The equity premium puzzle: what history (US 1889-2016)* implies

mean s correlation covariance

with consumption growth
ln cons. growth 0.0199 0.0342 1.0000 0.0012
ln S&P excess return 0.0457 0.1785 0.5626 0.0034
all figures are real (deflated)

We replace the moments in our equation

s 2 [ln Rt 1 ]
 f
E ln Rt 1  ln Rt 
2
 = s [  ln ct 1 , ln Rt 1 ]
with their sample counterparts** and solve for risk aversion.
  required to make our equation consistent with the data is 18.2

This seems high.

* Data from 1889 to 2009 are from Robert Shiller (chapt26.xlsx), from 2009 on from Datastream
** The formula was derived in a one-period model, where there is just one value for the risk-free rate.
In the data, there are multiple periods and the risk-free rate varies. It is not immediately obvious how
to best deal with this discrepancy. The common choice is to determine variances and covariances
with excess returns rather than with returns. Asset Pricing 67
Possible solutions 1: perhaps risk aversion is really that high –
but then we have a problem with the risk-free rate

Recall that for the risk-free rate we obtain

1
ln Rt f =  ln[ ]   E[ ln ct 1 ]   2s 2 [ ln ct 1 ]
2
The average log risk-free rate for the time span from above is 0.0166
So  = 18.2 implies a discount factor  = 1.15
 = 1.15 is implausible

Asset Pricing 68
Possible solutions 2: perhaps the equity premium is really not
that high

The standard error for the mean equity excess return in the data from
above is 1.6% (=> the true expected equity premium could be lower)

Survivorship bias:
– yes, we cannot easily conduct long-term studies for countries which
suffered economic disasters - or we do not regard them as important if
they did perform poorly
– but disasters often mean that the real risk-free rate is low

Possibly, one-time factors pushed up equity prices, especially in the last 60

years. In periods in which expected returns go down, stock prices go up
and thus realized returns are above expected ones.

=> Reducing the expected equity premium mitigates the problem but it’s still
hard to reconcile the data with our model
Asset Pricing 69
Possible solutions 3: modify the utility function by introducing
habits

Utility depends on consumption relative to habit X


(Ct  X t )1  1
t
E 
t =0 1
Risk aversion thus depends on how far consumption is above habit,
St = (Ct - Xt) / Ct
 Ct ucc (Ct  X t ) C t 
RRA = = =
uc (Ct  X t ) Ct  X t St

Consider an St fluctuating around 0.5:

– Obviously, for St = 0.5 relative risk aversion is larger than 
– Average relative risk aversion is larger than /0.5 as / St is convex in
St

Asset Pricing 70
Possible solutions 4: use data that better capture the actual
consumption behavior

Kroencke, Tim A. "Asset pricing without garbage." Journal of Finance 72

(2017): 47-98.

“[…] NIPA* consumption is filtered to mitigate measurement error. I apply a

simple model of the filtering process that allows one to undo the filtering
inherent in NIPA consumption. “Unfiltered NIPA consumption” well explains
the equity premium and is priced in the cross-section of stock returns. I
discuss the likely properties of true consumption (i.e., without measurement
error and filtering) and quantify implications for habit and long-run risk models.”

*National Income and Product Accounts

Asset Pricing 71
Other possible solutions

limited stock market participation (borrowing constraints...)

model the risk of rare disasters

introduce loss aversion (=> chapter 5: Prospect Theory)

Asset Pricing 72
Stock market predictability: The textbook evidence (here 1926-
2016 data from Goyal/Welch, t-statistics based on Newey/West)

ln(excess return t,t+k ) = a + b ∙ ln(D t/Pt) + ut,t+k

k b t(b) R²
1 0.067 1.385 0.024
3 0.203 2.094 0.073
5 0.332 3.015 0.129

If you haven‘t already done so, it‘s now a

good time to read Goyal/Welch (2003):
Predicting the equity premium with dividend
ratios, Management Science 49, 639-654.

Asset Pricing 73
Dividend-price ratio over time (Goyal/Welch data)

12%
10%
8%
Dt / Pt

6%
4%
2%
0%
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016

Asset Pricing 74
Stock market predictability: 5-year annualized excess returns and
5-year forecasts using dividend-price ratio (Goyal/Welch data)

Actual Forecast

20%
log excess returns p.a.

10%

0%

-10%

-20%
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016

Asset Pricing 75
Why regression coefficients increase with horizon

Since changes in the dividend-price ratio are persistent, predictability adds

up over long horizons
Consider example processes with log returns r and a predictor x.

rt 1 = bxt   t 1,
x t 1 =  x t   t 1
 rt 1  rt  2 = b (1   )xt  b t 1   t 1   t  2

Asset Pricing 76
Predictability and rationality – some introductory thoughts

One could argue like this:

– Predictability means that one can generate extra profits by basing an
investment strategy on dividend-price ratios
– But doesn’t this violate the efficient market paradigm? Shouldn’t we
expect prices to follow an unpredictable random walk?

Answers we explore are:

– No, we shouldn’t. Changing returns can reflect changes in risk premia.
Higher `profits’ are then not abnormal, but compensation for risk
– There’s no predictability anyway. It’s a statistical illusion

Asset Pricing 77
Some statistical doubts 1: Persistence means that a history of 80
years or so is actually quite short

Few years can change results substantially: on a 5-year horizon we have:

subsample 1926-1995 R²=0.265

subsample 1926-2002 R²=0.122
total sample 1926-2016 R²=0.129

Asset Pricing 78
Some statistical doubts 2: How to calculate standard errors of the
least squares coefficient b

With overlapping returns, we can no longer assume that error terms are
independent. Consider the data structure for five-year return regressions:

r1926,1931 = a  bx1926  u1926,1931

r1927,1932 = a  bx1927  u1927,1932
∙
∙
∙

r2011,2016 = a  bx 2011  u2011,2016

A commonly used estimator for standard errors in such a case is the one
by Newey/West. Ang/Bekaert (2006, Review of Financial Studies) show
that Newey/West may perform badly in predictability regressions because
of the persistence of the predictors. t-statistics are then typically
overestimated.
Alternative estimators (Hodrick 1992, Review of Financial Studies, or
bootstrap estimators) often turn significant statistics into insignificant ones.
Asset Pricing 79
Some statistical doubts 3: in-sample predictability does not
guarantee superior out-of-sample predictability

Out-of-sample analysis: The predictive performance of a model is evaluated

outside the sample that was used for estimating the model parameters. In
settings such as the one here, a walk-forward out-of-sample test is common:
Choose start date t.
Use information until t to make forecast for t+1.
Use information until t+1 to make forecast for t+2.
Continue until the end of your data.
Errors of out-of-sample regression forecasts and of prevailing historical mean
(one-year horizon, 1946-2016)
RMSE MAE
Regression 0.1714 0.1382
Historical mean 0.1720 0.1341
RMSE is root mean squared error, MAE is mean absolute error. In both cases
(regression, historical mean) expanding estimation windows starting in 1926
are used. The forecast for 1990, for example, uses data from 1926 to 1989.
Asset Pricing 80
An economic approach: Understanding the drivers of dividend-
price ratios

1 1 Pt 1  Dt 1
Start with identity: 1 = R Rt 1 = R
t 1 t 1
Pt
Pt  P D
 = Rt11 1  t 1  t 1
Dt  Dt 1  Dt
Take logs: p t  d t =  rt 1   d t 1  ln( 1  e p t  1  d t  1 )

Taylor series expansion around p-d:

P/D
pt  d t =  rt 1  d t 1  ln(1  P / D )   pt 1  d t 1  ( p  d )
1 P / D
=  rt 1  d t 1  ln(1  P / D )   ( p  d )   ( pt 1  d t 1 ),
P/D
where  = ( close to one)
1 P / D

Asset Pricing 81
Understanding the drivers of dividend-price ratios (continued)

pt  d t =  rt 1  d t 1  ln(1  P / D )   ( p  d )   ( pt 1  d t 1 )

Iterate forward and take expectations:


pt  d t = const.    j 1 d t  j  rt  j  (ex post)
j =1

pt  d t = const.  Et   j 1 d t  j  rt  j  (ex ante)
j =1

Which implies
 
j 1
  
j 1

var( pt  d t ) = cov pt  d t ,   d t  j   cov pt  d t ,   rt  j 
 j =1   j =1 

Asset Pricing 82
Understanding the drivers of dividend-price ratios (continued)

We obtained:

 
j 1
  
j 1

var( pt  d t ) = cov pt  d t ,   d t  j   cov pt  d t ,   rt  j 
 j =1   j =1 

Which implies that if the dividend-price ratio varies (which it does in the
data) it must be because
– it forecasts changes in returns and/or
– it forecasts changes in future dividends

Asset Pricing 83
Empirical evidence on the drivers of dividend-price ratios:
Variance decomposition (Cochrane, 1992)

Percent of the variance of the price-dividend ratio attributable to dividend

and return forecasts

Dividends Returns
Real -34 138
Std. error 10 32
Nominal 30 85
Std.error 41 19

The table shows the fraction of the variance (in %) that is attributed to dividend
and return forecasts, respectively. The infinite sum in the formula
 
j 1
  
j 1

var( pt  d t ) = cov pt  d t ,   d t  j   cov pt  d t ,   rt  j 
 j =1   j =1 
is approximated with a sum over the subsequent 15 years. Asset Pricing 84
Excess volatility: a mirror image of predictability

In an efficient market we have that price Pt = Et(P*t), P* being the present

value of actual subsequent dividends
Define forecast error ut = P*t - Pt
This gives Var[P*] = Var[u] + Var[P] and thus

Var[P*]  Var[P]

Empirical test: use actual dividends, assumption on final P* in data set and
assumption on discount rate to calculate ex post rational price for P*

Asset Pricing 85
Excess volatility: empirical evidence from Robert J. Shiller,
Speculative Asset Prices, Prize Lecture, 2013.

Asset Pricing 86
Explanations to previous slide

“To produce this figure, the present value of dividends for each date in 1871–
2013 was computed from the actual subsequent real dividends using a
constant real discount rate r = 7.6% per annum, equal to the historical average
real return on the market since 1871. […] I made some simple assumptions
about the as-yet-unseen future dividends, beyond 2013. This time I used a
conventional dividend discount model, the Gordon Model, using the most
recent 2013 S&P 500 real dividend as a base for forecasts of dividends after
2013 showing two alternative assumptions about dividends after 2013. In one, I
assumed that real dividends will grow forever from the last observed dividend,
in 2013, at the same average growth rate as over the most recent ten years,
5.1% per year, which gives a 2013 value of 1292 for P*. In another, the
calculations are the same but the growth rate of dividends after 2013 are taken
as the geometric average growth rate over the last thirty years, 2.5% a year.”
(Robert J. Shiller, Speculative Asset Prices, Prize Lecture, 2013, p. 468)

Asset Pricing 87
Why excess volatility is a mirror image of predictability

Saying that prices move to much is the same as

Saying that prices are sometimes too high, sometimes too low, which is the
same as
Saying that expected returns are sometimes lower (to bring prices that are
too high back to normal levels), sometimes higher (to bring prices that are
too low back to normal levels)
Conversely,
– if expected returns vary
– but we assume them to be constant when calculating excess volatility
– we will see excess volatility

Asset Pricing 88
Excess volatility: discount rates that would equate P and P* (for
data from Shiller)

14%
Discount rate used in t

12%
10%
8%
6%
4%
2%
0%

Asset Pricing 89
Univariate predictability: mean reversion in stock prices

Fama/French (1988): negative and significant b in

rt , t  k = a  b k rt  k , t   t  k

Poterba/Summers (1988): long-term variance ratios  below 1

var( rt ,t  k )
k =
k  var( rt 1 )

=> two ways of measuring the same thing

Asset Pricing 90
Univariate stock market predictability: (1926-2016 data from
Goyal/Welch)

Excess returnt,t+k = a+b∙ Excess returnt-k,t

k b t(b) R²
1 0.068 0.528 0.005
3 -0.157 -1.624 0.029
5 -0.057 -0.399 0.004

=> Predictability here appears low

=> Current literature doesn’t focus on univariate predictability

Asset Pricing 91
Predictability continues to be high on the research agenda:
Examples of recent papers

Rapach, David E., Jack K. Strauss, and Guofu Zhou. "Out-of-sample equity
premium prediction: Combination forecasts and links to the real economy."
Review of Financial Studies 23.2 (2010): 821-862.
“Welch and Goyal (2008) find that numerous economic variables with in-sample predictive
ability for the equity premium fail to deliver consistent out-of-sample forecasting gains
relative to the historical average. Arguing that model uncertainty and instability seriously
impair the forecasting ability of individual predictive regression models, we recommend
combining individual forecasts. Combining delivers statistically and economically significant
out-of-sample gains relative to the historical average consistently over time”
Guettler, A., P. Hable, and P. Launhardt. "The Out-of-Sample Predictive Power of
Aggregate Insider Trading." Working Paper (2016).
“In this paper, we investigate whether aggregate insider trading improves the performance
of models forecasting equity premia commonly considered in the literature. We show that
aggregate insider trading contributes to most of these benchmark models in statistical and
economic terms. Furthermore, our investigation reveals that in contrast to previous studies
which confine predictability to recession periods, aggregate insider trading provides
investors with an indicator to improve forecasts in expansion. Lastly, based on insiders’ and
short sellers’ ability to predict cash flows, our results suggest that combining insider and
short selling information yields a valuable model to forecast equity premia.”
Asset Pricing 92
Course outline

1. Introduction: finance basics

Some terminology and conventions, expected utility
2. The stochastic discount factor
Using the stochastic discount factor approach to understand returns on
risky and risk-free assets
3. Factor pricing models
The CAPM and the empirical evidence, multi-factor models
4. Aggregate stock price behavior
Equity premium puzzle
Time series predictability
5. Rationality and Behavioral finance
Bubbles, Prospect Theory

Asset Pricing 93
Rationality and Behavioral Finance – questions we examine

Bubbles: rational and irrational explanations

Some other phenomena that are/seem difficult to reconcile with rationality

Beyond expected utility theory: a new modeling framework that incorporates

psychology

Asset Pricing 94
 USD/BITCOIN
Dow Jones

50
100
150
200
250
300
350
400

2000
4000
6000
8000

0
10000
12000
14000
16000
18000
20000
Dec-18
Oct-16
Dec-20

Dec-22
Apr-17
Dec-24
Some bubbles?

Dec-26
Oct-17
Dec-28

Dec-30
Apr-18 Dec-32

Dec-34

Tesla NASDAQ composite

0
1000
2000
3000
4000
5000

50
0
100
150
200
250
300
350
400
450

Mrz 89
Dec-10
Mrz 91
Dec-11
Mrz 93
Dec-12
Mrz 95
Dec-13
Mrz 97
Dec-14
Mrz 99
Dec-15
Mrz 01
Dec-16
Mrz 03
Dec-17
Mrz 05
Asset Pricing 95
Bubbles: some examples

“Three dot.com IPO examples can be used to illustrate what was happening to
valuations at the time: (1) At Home listed on Nasdaq on July 11th 1997. This broadband
Internet business had just 5,000 subscribers when it announced it was going public and
warned that “there can also be no assurance that the Company will ever achieve
profitability”. Nonetheless, At Home’s opening market capitalization was no less than
$2bn, reflecting a price to sales ratio of 1350 times; in due course its market
capitalization reached $22bn. (2) eToys was floated on Nasdaq on May 20th 1999. By
the end of the first day of trading its price was up 280%, valuing the company at 220
times its revenues, or $7.8bn, substantially exceeding the market capitalization of
Toys’R’Us with sales almost 400 times larger. At its peak, eToys was valued at well over
$10bn, despite losing $4 on every order, even ignoring marketing costs. (3) Webvan was
an on-line grocery home delivery business which filed for an IPO in early August 1999,
just two months after it started selling groceries. Its prospectus forecast losses of over
half a billion dollars between 1999 and 2001! Nonetheless, when Webvan finally listed
on November 5th 1999 its stock rose by two thirds on the offer price, valuing the firm at
$8bn, 20,000 times its annualized revenues. The claims and the valuations proved
hopelessly unrealistic. At Home filed for bankruptcy at the end of September 2001,
eToys declared its shares worthless in February 2001 and Webvan filed for Chapter 11
in July 2001.”
(from Tuffler/Tuckett (2005) A psychoanalytic interpretation of dot.com stock valuations,
Working Paper) Asset Pricing 96
Bubbles

What is a bubble: A large price move (in particular a price increase

followed by a crash) that cannot (or is difficult) to explain with standard
pricing models

We look at some explanations:

– “rational bubbles”
– more elaborate rational models
– investor psychology

And an important question surrounding bubbles:

– Why don’t rational investors quickly bring prices back to normal
levels?

Asset Pricing 97
Rational bubbles


In chapter 2 we derived pt = Et m
j =1
t ,t  j x t  j

For an equity investment that you hold until t= this can be written as

pt = Et m
j =1
t , t  j dt  j  lim Et (m t ,t  j pt  j )
j 

If we do not impose the common assumption hat the expected discounted

asset price converges to zero as the horizon increases we get solutions
of the form 
pt = Et 
mt ,t  j dt  j  Bt
j =1

where Bt is the bubble component satisfying Bt = Et [ Bt 1 /(1  r )]

assuming that there is a constant discount rate representation.
Some (not all) theoretical requirements for rational bubbles:
– infinite horizon with finitely lived investors
– no upper limit on prices
Asset Pricing 98
An example for a rational bubble

Assume that there is a constant net discount rate r. A possible specification

of Bt is

 1  r 
  Bt   t 1 , with probability p
Bt 1 =  p 
 t 1 with probability 1  p

where E(t+1)=0

Asset Pricing 99
Another example for a rational bubble

Assume that there is a constant gross discount rate R. A possible

specification of Bt is

 Bt R  1
 R Bt , with probability
 Bt R  1

Bt 1 = 
 Bt R(  1)
1 with probability
  Bt R  1

Asset Pricing 100

A slightly more complex model can already change the picture*

Many people argue that there must be a bubble if valuation levels imply
unrealistic growth rates (or returns)
But: if the dividend growth rate is uncertain we have - assuming that the
discount rate r is constant and ignoring uncertainty about d1 in = :

p0  1  1
= E   >
d1  r  g  r  E(g )

Example, if p0/d1 = 200 and r = 0.15, the implied known and constant g is
0.145, which may seem too high. But assuming that g is either 0 or x, each
with probability 0.5, the implied x is 0.1475. So an expected growth rate of
0.5*(0+0.1475) = 0.074 is sufficient to explain the high valuation level if the
uncertainty about earnings growth is large

* Pastor/Veronesi (2005) Was there a NASDAQ Bubble in the Late 1990s?, Journal of Financial Economics 81, 61-100.

Asset Pricing 101

A yet more complex rational model*

A new technology arrives, but there is high uncertainty about the average
productivity of this new technology
Investors learn about this productivity before deciding whether to adopt the
technology on a large scale
For technologies that are ultimately adopted, the nature of uncertainty
changes from idiosyncratic (will this particular technology succeed?) to
systematic (once adopted across the economy, cash flows depend on
overall economic conditions)
=> There are two opposing valuation effects:
(a)Prices of technology stocks increase as investors learn that the
technology is likely to be successful
(b)Prices of technology stocks decrease as their systematic risk increases
because of adoption
We have a bubble-like pattern if effect (a) dominates first, effect (b)
afterwards
* Pastor/Veronesi (2009): Technological revolutions and stock prices, American Economic Review 99, 1451-83.

Asset Pricing 102

Bubbles: the irrationality view

“I can calculate the motions of the heavenly bodies, but not the madness of
people” (Isaac Newton, upon losing money in the stock market during the
so-called South Sea Bubble)
„We document a striking positive stock price reaction to the announcement
of corporate name changes to Internet-related dotcom names. (...) For
example, the Wall Street Journal reports that Computer Literacy, Inc.,
changed its name recently to fatbrain.com because customers kept
forgetting or misspelling its Internet address computerliteracy.com. The
shares of the company jumped by 33 percent to $20.75 the day before the
company sent out an advisory about a name change, when leaks about the
name hit Web chat forums“ (Cooper, Dimitrov, Rau, 2005, A rose.com by
any other name. Journal of Finance 56, 2371-2388)
„But how do we know when irrational exuberance has unduly escalated
asset values, which then become subject to unexpected and prolonged
contractions as they have in Japan over the past decade?“ (Alan
Greenspan, former Fed Chairman, 1996)

Asset Pricing 103

Bubbles: some internet postings before and after the internet
bubble burst

„Do you really think Yahoo and [its] business model in 2015 will be anything
like it is now? The whole idea of your comparison is based on the flawed
assumption that Yahoo will be much like it is now. What people see is that
Yahoo is becoming the [I]nternet brand and whatever the [I]nternet becomes,
Yahoo will be at the center of it as long as they take the right steps.
Information/communication/media/entertainment will all flow through Yahoo if
they play their cards right. The sky is the limit.“
a_bird_on_the_wire (msg #180245, 12/31/1999)

„Amazon] is like tulips in Holland. It will wilt, just like they did. People will get
hurt, because there is too much margin buying going on here. This is 1929,
times ten… Watch out.“ INETMktg (msg # 191300, 12/09/1999)

„[T]here is more to investing than buying, [I]t is called selling. Heard the
saying, bulls make money, bears make money, pigs like [you] get
slaughtered.“ rohith2 (msg #19554, 12/26/99)

The postings are quoted from Fisher, K., and M. Statman. "Sentiment, Value, Asset Pricing 104
and Market-Timing." The Journal of Investing 13.3 (2004): 10-21.
Bubbles: some internet postings (continued)

„My 1000 shares haven’t don’t too damn well recently. My broker advised me
to sell in 2000, and I resisted. I’m an idiot. But I’m going to buy more.“
mobuto1 (msg #186651, 07/09/02)

„Shorts are the avatars of divine perfection. Gardens of flowers spring in their
footsteps. The soft glow of their halos brings comfort in the darkest night.
When they breathe, gentle perfumed zephyrs fill the air...“
nostradomissays (msg #187329, 07/10/02)

The postings are quoted from Fisher, K., and M. Statman. "Sentiment, Asset Pricing 105
Value, and Market-Timing." The Journal of Investing 13.3 (2004): 10-21.
Behavioral Finance is built around anomalies and psychology

Anomaly
– A market phenomenon that cannot be explained by standard asset
pricing theory
– Examples: momentum (above average performance of short-term
winners), bubbles,…

Psychology
– Documents many individual deviations from rational expected utility
maximization
– Example: give too much weight to recent information (=> overreaction
to news)

Asset Pricing 106

Behavioral Finance vs. rational asset pricing

What they share

– Some market participants are less than rational
– Pricing irregularities do appear

The interpretation differs:

Behavioral Finance Rational asset pricing

anomalies persist …disappear or premium for risk
are economically significant but who has made money on it?
need to model irrationality need to investigate rational
behavior in complex environments

Asset Pricing 107

Reading

If you haven‘t already done so, it‘s now a good time to read

Thaler (2016). Behavioral economics: Past,

present, and future. American Economic
Review, 106, 1577-1600.

Fama (2014). Two pillars of asset pricing.

American Economic Review 104, 1467-1485.

Asset Pricing 108

Feedback effects as a Behavioral Finance explanation for the
internet bubble (cf. Shiller, 2003)

Psychological underpinnings
– Belief in trends even if clearly there are none
– Biased self-attribution: neglect information that questions the validity of
one’s beliefs or actions
– Representative heuristic: judge things based on their similarity with
what is regarded as typical
Applied to internet:
– Price increases lead to further increases due to extrapolation
– Disregard indicators of overvaluation (P/E ratios,…)
– Get fooled (Pay more for a stock just because a dotcom was added to
the name…)
Can of course be mixed with other elements:
– Greed
– Fraud
– …

Asset Pricing 109

Sometimes Behavioral Finance just studies anomalies without
detailed reference to psychology (cf. Lamont and Thaler, 2003)

3Com / Palm as one famous violations of the Law of one Price

– 3Com held 100% of Palm shares
– Then, 5% of Palm shares were sold to the public (“equity carve-out”).
3Com retained 95% of shares but announced that they would be
distributed to 3Com shareholders in about six months (“spin-off”); each
3Com shareholder would get 1.5 shares of Palm
– Prices on day of equity carve-out: 3Com: 82, Palm: 95
– Law of one Price: Price(3Com) >= 1.5 * Price(Palm)
Reference to psychology:
“Was [the Nasdaq Bubble] a rational process…or an investing frenzy based
on mob psychology? The fact that some investors were willing to pay more
to have one share of Palm than 1.5 embedded shares of Palm tells us that
the frenzy hypothesis is not altogether implausible” (Lamont, O., and R.
Thaler. "Anomalies: The law of one price in financial markets." The Journal of
Economic Perspectives 17 (2003): 191-202.
What complicates the interpretation: going short was difficult or impossible.
Also, people who understood the misvaluation might have bought Palm to
reap short term profits. Asset Pricing 110
How Behavioral Finance deals with the question why anomalies
are not exploited by rational market participants

Some evidence shows that even experts are prone to irrational biases
(other evidence, however, shows that successful people are less so)

Limits of arbitrage: Even if there are smart investors around, they do not
bring prices to their correct level because of
– Short sale constraints
– Risk of arbitrage

If you haven‘t already done so, it‘s now a

good time to read Brunnermeier/Nagel
(2005): Arbitrage at its limits: Hedge funds
and the technology bubble, Journal of
Finance 59, 2013-2040.

Asset Pricing 111

Reading

Kahneman/Tversky (1979): Prospect

theory: An analysis of decision under
risk. Econometrica 47, 263-291.

Asset Pricing 112

Prospect theory and expected utility theory compared

Prospect theory Expected utility

Perceive outcomes as gains and Perceive outcomes via their
losses impact on consumption level

Gains (losses) are outcomes above

(below) the reference point, which can
be the status quo, an aspiration
level or some other level.

Same person can be risk averse Risk preference mostly assumed

and risk loving depending on to be constant
situation

Weigh value of outcome with Weigh utility of consumption with

decision weights probabilities

Editing of prospects No editing. What matters are the

actual final consequences
Asset Pricing 113
Deriving the shape of the value function for prospect theory

Choice behavior reported in Kahneman/Tversky

Problem 13
(6,000, .25) or (4,000, .25; 2,000, .25)
[18] [82]
Problem 13‘
(-6,000, .25) or (-4,000, .25; -2,000, .25)
[70] [30]

from Problem 13: p(.25)v(6,000)< p(.25)[v(4,000)+v(2,000)]

from Problem 13‘: p(.25)v(-6,000)> p(.25)[v(-4,000)+v(-2,000)]
=> v(6,000) < v(4,000)+v(2,000) => v is concave for gains
=> v(-6,000) > v(-4,000)+v(-2,000) => v is convex for losses

Asset Pricing 114

Loss aversion in prospect theory

Loss aversion: once a risky situation includes possibility of loss, risk

aversion is much higher than if there is no possibility of loss
Why: kink in the value function at zero increases curvature

v(x)

Asset Pricing 115

Deriving characteristics of the weighting function for prospect
theory

Choice behavior reported in Kahneman/Tversky

Problem 14
(5,000, .001) or (5)
[72] [28]

p(.001)v(5,000) > v(5)

=> p(.001) > v(5) / v(5,000) > 0.001 (due to concavity of v)

Asset Pricing 116

Deriving characteristics of the weighting function for prospect
theory (continued)

Choice behavior reported in Kahneman/Tversky

Problem 8
(6,000, .001) or (3,000, .002)
[73] [27]

p(.001)v(6,000) > p(.002)v(3,000)

p(.001)/p(.002) > v(3,000)/v(6,000) > ½ (due to concavity of v)
p(.001) > ½ p(.002)

Asset Pricing 117

Explaining the Allais paradoxon (which expected utility theory
cannot explain)

Problem 1
(2,500, .33; 2,400, .66) or (2,400)
[18] [82]
Problem 2
(2,500, .33) or (2,400, .34)
[83] [17]

Problem 1: v(2,400) > p(.33)v(2,500)+p(.66)v(2,400)

=> [1-p(.66)]v(2,400) > p(.33)v(2,500)
Problem 2: p(.33)v(2,500) > p(.34)v(2,400)

=> 1-p(.66) > p(.34) => p(.66) + p(.34) < 1

Asset Pricing 118

Prospect theory and asset prices

Consider a reference point that is linked to past values, e.g. the price at
which an investor bought shares, or the values from the end of last year.
Whether a situation is considered as a gain or loss then depends on recent
performance, and so will risk aversion.

Impact on asset prices is similar to utility function with habit

– loss aversion increases risk aversion as does the introduction of
habits
– risk aversion is time-varying as in the case of habits

Asset Pricing 119

Some concepts and institutional knowledge

Asset Pricing 120

Corporate financing and investment

Structure of a corporate balance sheet

Assets Liabilities and Shareholders’ Equity

(where’s the money gone?) (where’s the money from?)
Machines Unpaid bills
Buildings Debt (bonds, bank loans)
Inventories Provisions
Cash …
…. Equity

Equity financing: Firm sells equity shares (stocks), shareholders get

dividends (if dividends are paid)
Debt financing: Firm sells bonds, bondholders get coupons and repayment
(if not => insolvency); similar with loans

Asset Pricing 121

Yields

The term yield is often used to denote the percentage cash return to the
owners of an asset. Examples:

– Dividend yield: Let the price of a stock be 50. It will pay a dividend of
0.75. The dividend yield is then 0.75/50 = 1.5%

– Bond yield: Let the price of a bond maturing in one year be 95. In one
year, it pays a coupon of 4 plus the principal of 100. The bond yield is
then 104/95 – 1 = 9.47%
Also called: yield to maturity or redemption yield. A bit more complex
to determine if the bond matures not in one year. The yield is then the
r that solves
T
Coupon t Principal
p0 =  
t =1 (1  r ) t (1  r )T

Asset Pricing 122

Trading of shares and bonds

Shares and bonds are usually traded on exchanges (NYSE, NASDAQ,

Deutsche Börse)
Trading partners
– Investors (You and me, funds, firms, banks…)
– Market makers and others who want to make money by trading
– Firms can also buy / sell their own shares
Trading costs: vary across stocks, size of trade etc. Can be 0.03%, can be
1.5% of the transaction volume.
Cost components
– Commissions
– Bid-ask-spread: you buy at the ask price and sell at the bid price, but
ask>bid.
– Market impact

Asset Pricing 123

Short selling

Short selling: sell a stock or another asset that you do not possess
How does it work?
– Find an institution or individual willing to lend you the stock
– Sell the stock on the stock market
– Post the proceeds as collateral with the lender
– Buy the stock at some later time, return it to the lender and receive the
collateral + rebate rate
– The rebate rate is lower than the market interest rate which means that
the lender gets a compensation for lending
Stock has to be returned when the lender recalls it or on a termination date
(if agreed)
Why does one want to sell short: benefit from falling stock prices, hedging

Asset Pricing 124

Measuring rates of return on the stock market (1): return
calculation

An investor holding a stock over one period return gets (p=stock price,
d=dividend) the following return:

pt  d t
Rt = (1  rt ) =
pt 1
=> For determining the return we therefore need prices and dividends.
We can chain returns together like we’ve seen before
R0,T = R1R2R3….RT
One usually talks about mean returns:
1 T
arithmetic mean: R =  Rt
T t =1
T 1/ T
geometric mean:  
RG =   Rt 
 t =1 
Asset Pricing 125
Measuring rates of return on the stock market (2): indices

A stock market index groups several stocks together. The index value
tracks the average price of the stocks
Important indices
– S&P 500 (500 large US stocks)
– Dow Jones (30 large US stocks)
– DAX (30 large German stocks)
Large is usually defined via market capitalization of a company
(= price per share times number of shares issued)
To calculate average price, index components are mostly weighted
according to market capitalization
Bond indices and other indices can be constructed in a similar fashion

Asset Pricing 126

Measuring rates of return on the stock market (3): risk premia

Stocks and other assets are risky. So it’s interesting to compare their
returns to the safe alternative.
The difference between the return on a risky asset R and the risk-free
return Rf is called excess return or risk premium
The average risk premium of stocks is called equity premium
To determine Rft we can:
– take the interest rate prevailing at t-1 for [t-1, t]
– take the return [t-1, t] on an index containing risk-free bonds

Asset Pricing 127

Earnings and dividends, payoffs and cash flows

A dividend paid in t is a payoff received in t from holding the stock

Note that earnings in t are not the same as the payoffs that shareholders
receive in t because some part of earnings are not immediately paid out as
dividends. They may be paid out in a later year t, but then they become
payoffs in year t, not in t
In some areas – especially when talking about investments of firms – we
would say cash flow instead of payoff but mean the same thing: it’s money
that a firm or an investor gets
If accounting is such that all changes to book value other than ownership
transactions are reflected in earnings,we get the clean surplus relation:

Book value of equity(t) = Book value of equity(t-1) + Earnings(t) – Dividends(t)

(Example for violation of clean surplus accounting: a firm issues shares as

employee compensation without treating them as expense)

Asset Pricing 128

Some (not all) technical prerequisites

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Statistics basics: variance, covariance and correlation

Unbiased sample estimators based on observations Xt, t=1,…,T-

1 T 1 T
Variance:
2
s =
X   X t  X  2
, X=  Xt
T  1 t =1 T t =1
1 T
Covariance: s XY =  X t  X Yt  Y 
T  1 t =1
s XY
 XY =
Correlation: s XsY

1 T
Autocorrelation of order j:   X t  X  X t  j  X 
T  1 t =1 j
s X2

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More on variance and covariance

 A useful result for random variables X,Y: E(XY) = E(X)E(Y) + cov(X,Y)

(derive from covariance definition: cov(X,Y) = E {[X-E(X)][Y-E(Y)]}

 Now consider a vector R: cov(R,R)= E [ (R-E(R)) (R-E(R))’ ]

and obtain:
Var(w‘R) = E [ (w‘R-E(w‘R))(w‘R-E(w‘R))‘ ]
= E [ w‘(R-E(R)) (w‘(R-E(R)))‘ ] = E[ w‘(R-E(R)) (R-E(R))‘w]
= w‘E [ (R-E(R)) (r-E(R))‘ ] w = w’cov(R,R)w

cov(R,w‘R) = E [ (R-E(R)) (R-E(R))‘ ] w = cov(R,R)w

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Regression basics

See the section on regression in the hand-out

I don’t expect you to know formulae like b = (X’X)-1X’y by heart but
it’s good to know what’s going on in a regression and what may cause
problems

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Derivative of a quadratic form

Assume w is N × 1, A is N × N with elements aij and we want to find

the derivative of s=w’Aw with respect to w.

N N
Note: s =  aij wi w j
j =1 i =1
N N
s
Differentiate with respect to the kth element of w: w =  akj w j   aik wi
k j =1 i =1

Assemble these derivatives in a vector to get  s 

 w 
s  1 
=  ...  = A' w  Aw
w
 s 
 wN 
 

s
Which for symmetric matrices simplifies to: = 2 Aw
w irm 133
The lognormal distribution

X follows lognormal distribution with parameters (μ, σ²) if ln(X) is normal

with mean μ = E[ln(X)] and variance σ² = σ²[ln(X)]
E[X]= exp (μ + σ²/2)
σ²[X]= exp(2μ+σ²)(exp(σ²) – 1)

Density of ln(X) with μ=0, s=1 Density of X

-5 -4 -3 -2 -1 0 1 2 3 4 5 0 2 4 6 8 10
ln(X) X

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Taylor approximation

1st order (linear) approximation of a function

f ( x1 ) = f ( x0 )  f ' ( x0 )( x1  x0 )

2nd order (quadratic) approximation

1
f ( x1 ) = f ( x0 )  f ' ( x0 )( x1  x0 )  f ' ' ( x0 )( x1  x0 ) 2
2

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The inversion method for random number generation

To draw a random number that follows a distribution F, draw a random

variable U that is uniformly distributed on (0,1) and then use F-1 (U).

Proof:
Pr ( F-1 (U) ≤ x ) = Pr ( U ≤ F(x) ) = F(x)

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 Some hints for EXCEL

What? German legacy English legacy English current

Run regression =RGP() =Linest() =Linest()
Arithm. Average =Mittelwert() =average() =average()
Standard deviation =stabw() =stdev() =stdev.s()
Natural logarithm in Excel =ln() =ln() =ln()
Natural logarithm in VBA =log() =log() =log()
Raise x to power n =x^n =x^n =x^n
Quantile of standard normal =standnorminv() =normsinv() =norm.s.inv()
Density of standard normal =normvert(x,0,1,0) =normdist(x,0,1,0) =norm.dist(x,0,1,0)
Cumulative standard normal =standnormvert() =normsdist() =norm.s.dist()
Uniform random number =zufallszahl() =rand() =rand()

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