MT - 08. Asset Pricing

Question 1

Topic Summary (5)

Answer 1

Asset market data cause issues for economic models

1. Difficult to justify magnitudes 6.18% equity premium and the incredibly low risk-free rate
   - Mehra and Prescott (1985), Weil (1989), Hansen and Jagannathan (1991)
2. Difficult to justify 19% annual market volatility bounds
   - Shiller (1981), LeRoy and Porter (1981)
3. Conditional variance of market return is a.) Time varying, b.) Very Persistent
   - Mehra and Prescott (1985), Wel (1989), Hansen and Jagannathan (1991)
4. Cross section of asset returns usually explained by risk, but different covariances of returns and contemporaneous consumption growth across portfolios do not explain the returns we see in US stocks
   - Mankiw and Shapiro (1986), Campbell (1996), Cochrane 1996)
5. Financial frictions models introduce a wedge into the Euler equation –> Easier to microfound

Question 2

Seminal Papers (8)

Answer 2

• Mehra and Prescott (1985), Weil (1989), Hansen and Jagannathan (1991)
• Shiller (1981), LeRoy and Porter (1981)
• Mankiw and Shapiro (1986), Campbell (1996), Cochrane 1996)

Question 3

Bansal and Yaron (2004)

Answer 3

Aim: explore how news about growth rates and uncertainty might influence long run expectations, and hence show how asset prices can be sensitive to small news today about growth rate and uncertainty

Conclusion: model can explain magnitudes of both equity risk premium and risk free rate, but also explain volatility of risk free rate and market return.

Question 4

Parker and Julliard (2005)

Answer 4

Aim: explore how the key insight from CCAPM model: asset expected return is determined by equilibrium risk to consumptions.

Conclusion: confirms the CCAPM –> that consumption risk is key in asset returns, but ultimate consumption risk (not contemporaneous covariances) explains 44-73% of the variation in expected return across portfolios.

Question 5

Barro (2005)

Answer 5

Aim: extend the low probability event argument as a plausible explanation for the EP puzzle

Conclusion: this approach can explain many puzzles whilst maintaining tractability.

Question 6

Campbell (1999)

Answer 6

– models must have risk is highly priced, time varying and correlated with state of economy to understand asset pricing

Question 7

Campbell and Cochrane (1999)

Answer 7

– explain procyclical stock prices, countercyclical volatility, SR and LR equity premium puzzles despite low risk free rate –> slow moving external habit to standard power utility –> Slow countercyclical variation in risk premia, fear stocks as do poorly in recessions!