Consumption based asset pricing models use marginal rates of substitution to determine the relative prices of the date, eventcontingent, composite consumption good. If no riskfree rate, rf should be interpreted as blacks 1972 zerobeta. Explore the asset pricing implications of the neoclassical model 2. Cochrane begins powerfully, introducing us to the notion that the consumption based asset pricing equation, given by an investors firstorder conditions, is the central formulation in asset pricing. Themarginalutility loss of consuming a little less todayand buying a little more of the asset. The consumption based and general equilibrium models described below are the purest examples of this approach. Data from other countries are examined to see which features of the us experience apply more generally. Under general equilibrium theory prices are determined through market pricing by supply and demand.
This week well look at the discount factor in more detail. A consumption based explanation of expected stock returns 541 higher than the eis. Consumptionbased asset pricing with a reference level. I incorporate loss aversion in a consumptionbased asset pricing model with recursive preferences and solve for asset prices in closedform. Inabsolute pricing, we price each asset by reference to its exposure to fundamental sources of macroeconomic risk. Financial economics consumptionbased capm consumptionbased capm as equation 2 holds for any asset i, we could subtract the equation for one asset from the equation for another asset to ge t 0 e 1. The consumption based capital asset pricing model ccapm is a model of the determination of expected i. Consumption based asset pricing model the consumption based capital asset pricing model ccapm presented below depends on a number of assumptions regarding the model structure. He introduces students to leading theories of portfolio choice, their implications for asset prices, and empirical patterns of risk and return in financial markets.
Consumption capital asset pricing model ccapm definition. A financial model that extends the concepts of the capital asset pricing model capm to include the amount that an individual or firm wishes to. On the one hand, most of the empirical factor models that can successfully explain risk premia do not provide strong guid. Consumptionbased asset pricing models use marginal rates of substitution to determine the relative prices of the date, eventcontingent, composite consumption good. However, the basic crralognormal version of the ccapm is shown to be unable to match a number of stylized empirical asset pricing facts and thus leaves a number of puzzles, such as. Topics in asset pricing hebrew university of jerusalem. Pdf the consumptionbased capital asset pricing model. Introduction to asset pricing theory the theory of asset pricing is concerned with explaining and determining prices of. Topics in asset pricing lecture notes download book. Theory the essential element in modern asset pricing theory is a positive random variable called the stochastic discount factor sdf.
Based on some approximations or an assumption of crra utility and lognormal consumption, the socalled consumption based capm or ccapm is derived and interpreted. He and modest 1995, market frictions and consumption based asst pricing, journal of political economy 103, 94117. In financial decisions and markets, john campbell provides a broad graduatelevel overview of asset pricing. The consumptionbased capital asset pricing model article pdf available in econometrica 576.
The course is selfcontained and not based on any one book. Dynamic asset pricing theory provisional manuscript. The chapter lists some important stylized facts that characterize us data, and relates them to recent developments in equilibrium asset pricing theory. Then he quickly outlines the huge literature of responses to the puzzles p. An overview of asset pricing models university of bath.
Now use the consumption capital asset pricing equation previous problem to derive the equilibrium interest rate of the risk free bond. January 8, 2014 abstract we investigate the empirical performance of a simple twofactor consumption based asset pricing model for the crosssection of equity returns. Consumption based asset pricing models use marginal rates of substitution to determine the. Financial decisions and markets princeton university press. Consumptionbased capital asset pricing model wikipedia. How can consumptionbased assetpricing models explain. Written by a major contributor to the economics of financial markets, financial decisions and markets is a comprehensive, insightful, and authoritative graduatelevel introduction to asset pricing. This book advocates a discount factor generalized method of. A brief introduction to the consumption based asset pricing model ccapm we have seen that capm identifies the risk of any security as the covariance between the securitys rate of return and the rate of return on the market portfolio.
Artem, 923 vayanos 1998, transaction costs and asset prices. According to the capm, the uncertainty associated with the return on the market portfolio is the sole. An investors firstorder conditions give the basic consumption based. In examining the empirical performance of this class of models, several puzzles are discovered.
This is the famous paper that launched the consumptionbased model and endowmenteconomy framework. Understand the pricing of insurance and aggregate risk 3. The recent theoretical literature is used to guide the exploration of the international data. This book gives an overview of the most widely used theories in asset pricing and. Asset pricing wikibooks, open books for an open world. Ljunqvist and sargent, recursive macroeconomic theory for coverage of dynamic programming, as well as two excellent chapters on asset pricing.
In finance, the capital asset pricing model capm is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a welldiversified portfolio. Bansal and yaron 2004, hansen, heaton, lee, and roussanov 2007, bansal, kiku, and yaron 2012, but are also supportive of a broader class of consumption based asset pricing models. A singlefactor consumptionbased asset pricing model. Here asset prices jointly satisfy the requirement that the quantities of each asset supplied and the quantities demanded must be equal at that price so called market clearing. The discount factor framework also leads to a statespace geometry for meanvariance frontiers and asset pricing models. Chapter 6 on consumption based asset pricing is likewise elegant and comprehensive. How can consumptionbased assetpricing models explain low.
Optimal dynamic trading with informational advantage 7. I find loss aversion increases expected returns substantially relative to the standard recursive utility model. The paper also extends the equilibrium characterization of interest rates of. No part of this book may be distributed, posted, or. The asset pricing model that is embedded in stochastic models of macroeconomics is called the consumption based asset pricing model ccapm. An overview of asset pricing models andreas krause university of bath school of management phone. A major research initiative in finance focuses on the determinants of the crosssectional and time series properties of asset returns.
Problem 1 consumption based capital asset pricing model. He presents applications to stocks, bonds, and options. From capm to market anomalies, credit risk implications for the cross section of asset returns, rational versus behavioural attributes of stylized crosssectional effects, conditional capm, conditional versus unconditional portfolio efficiency, multifactor models, interpreting factor models, machine. This book gives an overview of the most widely used theories in asset pricing and some more. John cochranes book asset pricing comes closest to the course in terms of topics. Each model consumption based, capm, multifactor, term structure, and option pricing is derived as a different specification of the discounted factor. Consumption based asset pricing 2 1 overview from macroeconomics, here are the equations that describe the aggregate production function. Asset pricing and portfolio choice theory second edition. May 16, 2006 abstract this paper presents an empirical evaluation of recently proposed asset pricing models which extend the standard preference speci. A brief introduction to the consumption based asset. Notes and references 175 part two dynamic models 8. The paper also extends the equilibrium characterization of interest rates of cox. Many of those works, finance journal publications and the literature on asset pricing in general, set their focus on different parts of this paper, which again underlines the.
Unfortunately, consumptionbased asset pricing models prove disappoint ing empirically. For debt, asset pricing is relatively simple, as cash flows to the owner are contractually fixed. The capm model deals with the question of how asset prices and yields are determined, under the hypothesis that the riskfree interest rate and market return are variables determined outside the model. Jun 22, 2019 consumption capital asset pricing model ccapm. Cochrane abstract we show that the external habitformation model economy of campbell and cochrane 1999. I conclude that these indices, which are approximations to the consumption of the rich, provide a useful vantage point from which we can reassess the theory of consumption based asset pricing. This feature of my model improves the ability to match moments on asset prices.
Growth theory has been concerned with achieving higher per capita. Chapter 12 advances in consumption based asset pricing. Consumptionbased model and overview princeton university. The consumptionbased capital asset pricing model ccapm is a model of the determination of expected i. Introduction despite their universal importance, asset pricing models are usually characterized by a puzzling contradiction. Consumptionbased model and overview an investor must decide how much to save and how much to consume, and what portfolio of assets to hold. Consumption is the ultimate objective of investment. The foundations of this concept were laid by the research of robert lucas 1978 and douglas breeden 1979.
The asset prices we discuss would include prices of bonds and stocks, interest rates, exchange rates, and derivatives of all these underlying. Limitations of the capital asset pricing model capm. Consumptionbased asset pricing models academic web pages. Take asset j as the riskfree asset, with return d a j r d t. Your results should be the same, since both derivations are based on the euler equation. An alternate title might be arbitrage, optimality, and equilibrium, because the book is built around the three basic constraints on asset prices. Capm, icapm, apt, option pricing, and finally consumptionbased model. Request pdf consumption based asset pricing models. Abstract this paper examines linear asset pricing models using aggregate consumption data which are not seasonally adjusted.
These topics are derivatives pricing and hedging the blackscholesmerton, the heathjarrowmorton, and the reducedform credit risk models, multiplefactor models, characterizing systematic risk, portfolio optimization, market efficiency, and equilibrium capital asset and consumption pricing models. Basic consumptionbased asset pricing oxford scholarship. This book stresses the interplay between theory, econometrics, and empirics, the hallmark of john campbells research. This model class is characterized by a stochastic discount factor process that puts restrictions on the joint process of asset returns and per capita consumption. Consumptionbased asset pricing with loss aversion by. This paper provides conditions on the primitives of a continuoustime economy under which there exist equilibria obeying the consumptionbased capital asset pricing model. The ccapm links asset pricing with macroeconomic risk.
Explaining the poor performance of consumptionbased asset. In financial decisions and markets, john campbell, one of the fields most respected authorities, provides a broad graduatelevel overview of asset pricing. New evidence from the crosssection of stock returns joachim grammig and andreas schrimpf. This research has propelled further interest in consumption based asset pricing, as well as some debate. A consumptionbased explanation of expected stock returns 541 higher than the eis. Consumption based asset pricing models the discount factor representation of asset pricing models the equity premium puzzle the risk free rate puzzle the epsteinzin preferences long run risk habit formation prospect theory 3 professor doron avramov.
The model is a generalization of the capital asset pricing model capm. Defend the assumption that the amount of risk free bond is in zero net. This book gives an overview of the most widely used. Pastor and stambaugh 2002, liquidity risk and expected stock returns, working paper, chicago and wharton. The consumption based capital asset pricing model by darrell duffie and william zame1 the paper provides conditions on the primitives of a continuoustime economy under which there exist equilibria obeying the consumption based capital asset pricing model ccapm. A simple consumptionbased asset pricing model and the cross. Explaining the poor performance of consumptionbased. Most importantly, risk corrections to asset prices should be driven by the covariance of asset. With that objective in mind, asset pricing models have been developed, starting with the capital asset pricing models of sharpe 1964, lintner 1965, and mossin 1966. The name derives from the fact that the equations that describe the behaviour of asset prices and returns in the ccapm devolve from the consumption saving and asset choice decisions of households. An overview of asset pricing models university of bath bath. A consumptionbased explanation of expected stock returns. Portfolio returns exhibit more diverse and often stronger consumption correlations, and the parameters of. The ccapm built on the classic singleperiod, marketbased capm of sharpe 1964 and lintner 1965 as well as on the subsequent major work on the intertemporal capm icapm by merton 1973.
Asset pricing is developed around the concept of a stateprice deflator which relates the price of any asset to its future risky dividends and thus incorporates how to adjust for both time and risk in asset valuation. Chapter 12 advances in consumptionbased asset pricing. Financial asset pricing theory offers a comprehensive overview of the classic and the current research in theoretical asset pricing. If the risky return covaries negatively with tomorrows consumption then the lhs is negative and the asset return bears a negative premium over the risk free rate. The family of consumption based asset pricing models yields a stochas tic discount factor proportional to the mar ginal rate of intertemporal substitution of consumption.
A brief introduction to the consumption based asset pricing. The course then turns to the capital asset pricing model capm and consumption based asset pricing model, and develops dynamic portfolio choice problems and equilibrium asset pricing theories. First, small stocks and value stocks have higher durable consumption betas than big stocks and growth stocks. Simply put, the returns on small stocks and value stocks are more procyclical, explaining their high average returns. Understand the quantitative limitations of the model. In consumptionbased assetpricing models there are no liquidity constraints or other transaction costs, so agents can trade assets freely at each period. John jumps right in to data with the equity premium, riskfree rate, and volatility puzzles p. We will now use the euler equation to derive an asset pricing equation. Stochastic discount factor prices all assets this conceptually simple view holds. Fundamental equation of consumptionbased asset pricing. The consumption capital asset pricing model ccapm is an extension of the capital asset pricing model capm that uses a consumption beta instead of a market beta to explain expected return premiums over the riskfree rate.
Download it once and read it on your kindle device, pc, phones or tablets. This book is an introduction to the theory of portfolio choice and asset pricing in multiperiodsettings under uncertainty. Continuoustime asset pricing theory a martingalebased. Review article full text access chapter 12 tests of multifactor pricing models, volatility bounds and portfolio performance.