SCHOOL OF FINANCE AND APPLIED ECONOMICS

Bachelor of Business Science – Financial Economics

END OF SEMESTER EXAMINATION [SOLUTION]

BSE 4115:- ECONOMIC ANALYSIS OF ASSET PRICES

DATE: July 2015 TIME: 2 hours

Instructions

Attempt question ONE and any other TWO questions. Clearly define all notations used and show
all your workings.

a) Suppose that the rate of return on the stock of a Company is observed to follow a
martingale process. Explain what this means in terms of the properties of the rate
of return over time. What can be inferred from this observation about the efficiency
or inefficiency of the market for the Company’s stock? [4 Marks]

Martingale hypothesis formalizes the price process of a stock as:

𝐸[𝑝1+1 |𝛺𝑡 ] = 𝑝𝑡

Hence the martingale hypothesis predicts a zero expected return:

𝐸[𝑝𝑡+1 − 𝑝𝑡 |𝛺𝑡 ]/𝑝𝑡 = 0

The martingale hypothesis can be tested from a time series of data on the rate
of return and the elements of the information set. The martingale hypothesis
implies that these covariances are zero, a hypothesis that can be tested. If the
tests do not reject the model, the evidence supports efficiency conditional upon
the martingale model and the set of information used in the tests. If the tests

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 reject the martingale assumption, this is evidence of inefficiency. But this
evidence is conditional on the martingale assumption. Another model might yield
different results.

b) Define an investor’s utility of consumption in a two period framework as

𝑈(𝐶𝑡 , 𝐶𝑡+1 ) = 𝑢(𝐶𝑡 ) + 𝛽𝐸[𝑢(𝐶𝑡+1 )]

Where 𝐶𝑡 and 𝐶𝑡+1 is consumption in period one and two respectively, 𝑈(. ) denotes
utility and 𝛽 accounts for discounting effects and investor exhibits a power utility
1−𝛾
𝐶𝑡
function of the form 𝑈(𝐶𝑡 ) = 1−𝛾
. Assume that the current wealth of the investor is

given by 𝑒𝑡 and that the investor can fund part of his consumption in the second
period by investing in 𝜉 units of an asset at a cost 𝑃𝑡 with a payoff 𝑥𝑡+1 .

Derive the basic pricing formula clearly explaining any assumptions made [6
Marks]

c) After graduating, you decide to use your fresh knowledge in Asset Pricing and
start your own hedge fund. You conduct statistical analysis and identify a
particularly promising portfolio of stocks, which you call MightyPot. Your analysis

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 reveals that the MightyPot portfolio has an expected return of 9% with a standard
deviation of 10%. You also expect The NSE 20 portfolio, which you use as the
proxy for the market portfolio, to have an expected return of 11% with a standard
deviation of 20%. The risk-free rate is a constant 6%.

Based on the information provided so far, can you tell whether the CAPM is
violated in this economy? If your answer is yes, explain how. If your answer is no,
explain what other information you would need to decide. [4 Marks]

Yes, the CAPM is violated in this economy. To see this point, calculate the Sharpe
ratios of the MightyPot portfolio and the market portfolio respectively, we get:

9% − 6%
𝑆𝑝 = = 0.3
10%
11% − 6%
𝑆𝑚 = = 0.25
20%

The CAPM tells that the market portfolio is also the tangency portfolio, so that
it should have the highest Sharpe ratio. However, we see that the SuperValue
portfolio has a higher Sharpe ratio than the market. Hence, the CAPM is violated.

d) State the Hansen-Jagannathan bound and explain what it measures. Support your
explanations with suitable workings. [8 Marks]

Hansen and Jagannathan (HJ) provide an alternative perspective on the puzzle. Hansen–
Jagannathan bound is a theorem in financial economics that says that the ratio of the
standard deviation of a stochastic discount factor to its mean exceeds the Sharpe Ratio
attained by any portfolio. ) The HJ give us a clearer understanding of why certain asset
pricing models are rejected by the data. It allows us to compare asset pricing models
against one another and helps to identify features of the data that present the most
stringent restrictions on asset pricing models.

The fundamental pricing equation can be written as:

𝑀𝑡+1 , 𝑅𝑒,𝑡+1
𝐸𝑡 (𝑅𝑒,𝑡+1 ) = 𝑅𝑓,𝑡+1 + 𝐶𝑜𝑣𝑡 { }
𝐸𝑡 (𝑀𝑡+1 )

This expression holds unconditionally so that

𝐸(𝑅𝑒,𝑡+1 ) = 𝑅𝑓,𝑡+1 + 𝜎(𝑀𝑡+1 )𝜎(𝑅𝑒,𝑡+1 )𝜌𝑅,𝑀 /𝐸(𝑀𝑡+1 )

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 or 𝐸(𝑅𝑒,𝑡+1 ) − 𝑅𝑓,𝑡+1 /𝝈(R 𝒆,𝒕+𝟏 ) = 𝝈(Mt+1 )ρR,M /𝐸(𝑀𝑡+1 )

and since −1 ≤ 𝜌𝑅,𝑀 ≤ 1

|𝐸(𝑅𝑒,𝑡+1 ) − 𝑅𝑓,𝑡+1 /𝜎(𝑅𝑒,𝑡+1 )| ≤ 𝜎(𝑀𝑡+1 )/𝐸(𝑀𝑡+1 )

This inequality is the Hansen- Jaggernathan lower bound on the pricing kernel.

e) Asset pricing is one of the fields in economics where academic research has had the
most impact on non-academic practice. The waves of research following the original
contributions of the 2013 Laureates in Economic Sciences constitute a landmark example
of highly fruitful interplay between theoretical and empirical work. There however
remains some issues that remain unresolved in the empirical tests of the theoretical
underpinnings of Asset Pricing. Some of the notable issues including issues include the
increasing consideration of behavioural aspects in asset pricing and the joint hypothesis
problem.

Discuss the implications of a behavioral approach to Asset Pricing as fronted by Shefrin

(2005, 2008), clearly outlining the impact on the Stochastic Discount Factor,
Fundamental value and the Market Risk Premium. [8 Marks]

• Behavioural Stochastic Discount factor – reflect investor bias as a function of investor

sentiment relative to fundamental value.

• Market sentiment is a major determinant of asset pricing. It is derived from systematic

errors in judgment.

• Sentiment causes asset prices to deviate from values determined using traditional finance
approaches.

• Sentiment Risk Premium

• Discount rate captures:

- Time value of money – risk free rate;

- Fundamental risk – efficient market premium;

- Sentiment risk – sentiment premium

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QUESTION TWO

a) Derive using suitable workings the pricing relation under the Arbitrage Pricing
Theory (APT). What are the implications of this result for modelling asset prices.
[12 Marks]

To derive the pricing relation start with the return generating process as:

𝑟𝑖 = 𝛼𝑖 + 𝛽1𝑖 𝐹1 + 𝛽2𝑖 𝐹2 + ⋯ + 𝛽𝑘𝑖 𝐹𝑘 + 𝜀𝑖

Taking expectations we get:

𝐸(𝑟𝑖 ) = 𝛼𝑖 + 𝛽1𝑖 𝐸(𝐹1 ) + 𝛽2𝑖 𝐸(𝐹2 ) + ⋯ + 𝛽𝑘𝑖 𝐸(𝐹𝑘 ) + 𝜀𝑖

Subtracting second from first equation gives:

𝑟𝑖 − 𝐸(𝑟𝑖 ) = [𝛼𝑖 + 𝛽1𝑖 𝐸(𝐹1 ) + 𝛽2𝑖 𝐸(𝐹2 ) + ⋯ + 𝛽𝑘𝑖 𝐸(𝐹𝑘 ) + 𝜀𝑖 ]

− [𝛼𝑖 + 𝛽1𝑖 𝐸(𝐹1 ) + 𝛽2𝑖 𝐸(𝐹2 ) + ⋯ + 𝛽𝑘𝑖 𝐸(𝐹𝑘 ) + 𝜀𝑖 ]

The above relationship can be written as:

𝐾

𝑟𝑖 = 𝐸(𝑟𝑖 ) + ∑ 𝛽𝑖𝑘 [𝐹𝑘 − 𝐸(𝐹𝑘 )] + 𝜀𝑖

𝑘=1

Next construct an 𝐼 asset portfolio with return 𝑟𝑝 = ∑𝑁

𝑛=1 𝑋𝑖 𝑟𝑖

Pluging the individual returns 𝑟𝑖 into the portfolio return formula yields:
𝐼 𝐼 𝐾 𝐼

𝑟𝑝 = ∑ 𝑋𝑖 𝐸(𝑟𝑖 ) + ∑ ∑ 𝑋𝑖 𝛽𝑖𝑘 [𝐹𝑘 − 𝐸(𝐹𝑘 )] + ∑ 𝑋𝑖 𝜀𝑖

𝑖=1 𝑖=1 𝑘=1 𝑖=1

In a well-diversified portfolio the last term, idiosyncratic risk, disappears.

The APT equilibrium condition is the absence of arbitrage which implies the following
if you build a well-diversified portfolio then∑𝐼𝑖=1 𝑋𝑖 𝜀𝑖 = 0. Further:

1. The portfolio requires no initial investment meaning ∑𝐼𝑖=1 𝑋𝑖 = 0; sum of portfolio

weights is equal to zero;

2. That the no arbitrage portfolio involves no risk i.e. ∑𝐾

𝑘=1 𝑋𝑖 𝛽𝑖𝑘 = 0 ; for all k,

then;

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 3. The expected return must be zero ∑𝐼𝑖=1 𝑋𝑖 𝐸(𝑟𝑖 ) = 0

Implications for modelling

The three no arbitrage conditions can be interpreted as orthogonality conditions for

linear algebra as:

1. ∑𝐼𝑖=1 𝑋𝑖 = 0; sum of portfolio weights is equal to zero; means vector of weights is

orthogonal to a vector of 1s;

2. ∑𝐾
𝑘=1 𝑋𝑖 𝛽𝑖𝑘 = 0 ; for all k, means the vector of weights is orthogonal to the vector

of sensitivities; and

3. The expected return must be zero ∑𝐼𝑖=1 𝑋𝑖 𝐸(𝑟𝑖 ) = 0

This means that the last vector must be a linear combination of the other two vectors:

𝐸(𝑟𝑖 ) = 𝜆0 + 𝜆1 𝛽1𝑖 + 𝜆2 𝛽2𝑖 + ⋯ + 𝜆𝑘 𝛽𝑘𝑖

Constructing a risk free portfolio would yield:

𝑟𝑓 = 𝜆0 + 𝜆1 0 + 𝜆2 0 + ⋯ + 𝜆𝑘 0 = 𝑟𝑓

Constructing risky portfolios with sensitivities of 1 to one factor and zero to all other
factors; for example factor 1 yields

𝐸(𝐹1 ) = 𝑟𝑓 + 𝜆1 1 + 𝜆2 0 + ⋯ + 𝜆𝑘 0 𝑠𝑢𝑐ℎ 𝑡ℎ𝑎𝑡 𝜆1 = 𝐸(𝐹1 ) − 𝑟𝑓

Repeat for all factor and you will get the famous APT equilibrium pricing relationship
𝐾

𝐸(𝑟𝑖 ) = 𝑟𝑓 + ∑ 𝛽𝑖𝑘 [𝐸(𝐹𝑘 ) − 𝑟𝑓 ]

𝑘=1

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b) State the condition defining a speculative bubble in an asset price. Does the
rational expectations assumption rule out the presence of a speculative bubble
in asset prices? [8 Marks]

Asset price bubbles—by analogy with ‘bubbles’ in general—expand rapidly, are

fragile and are liable to burst without warning. In the context of asset prices,
bubbles are characterised by rapid price increases, sometimes to the point of a
speculative mania of price increases. The price increases often reach a frenzied
climax that may be sustained for weeks or even months. Then following a news
story or revelation of information (that may or may not seem relevant at the
time), the bubble is pricked and prices fall, sometimes accompanied by
increased volatility (i.e. short-lived violent price declines and increases).

Asset price bubbles are often associated with — either as cause or effect — other
economic events, particularly (a) general price inflation (before the bubble
bursts) and deflation (following the burst); (b) economic prosperity, followed by
decline (following the bubble’s burst); (c) allegations of fraud, embezzlement
and dishonesty.

QUESTION THREE

a) In one of the discussions with your friends Alison and Bright make the following
statements:

Alison: All assets have an expected return equal to the risk-free rate, plus a risk
adjustment. Those assets whose returns covary positively with consumption
make consumption more volatile, and as such must promise higher expected
returns to induce investors to hold them.

Bright: One amazing implication of the basic asset pricing equation is that asset
returns that covary less with consumption require less compensation for risk.
In fact those assets whose returns negatively covary with consumption can

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 offer expected rates of return that are lower than the risk-free rate, or even
negative expected returns.

i. State whether the statements made by Alison and Bright are True or False.

[2 Marks]

ii. Justify your responses in (i) above using suitable workings

[10 Marks]

Alison – TRUE - All assets have an expected return equal to the risk-free rate, plus a
risk adjustment. Assets whose returns covary positively with consumption make
consumption more volatile, and so must promise higher expected returns to induce
investors to hold them.

Bright – TRUE - Conversely, assets that covary negatively with consumption can offer
expected rates of return that are lower than the risk-free rate, or even negative
(net) expected returns.

Using the definition of covariance 𝑐𝑜𝑣(𝑚, 𝑥) = 𝐸(𝑚𝑥) − 𝐸(𝑚)𝐸(𝑥), we can write the
basic pricing equation as

𝑝 = 𝑐𝑜𝑣(𝑚, 𝑥) + 𝐸(𝑚)𝐸(𝑥).
1
Substituting the risk-free equation, we obtain since 𝐸(𝑚) = 𝑅
𝑓

𝐸(𝑥)
𝑝= + 𝑐𝑜𝑣(𝑚, 𝑥).
𝑅𝑓

The first term is the standard discounted present value formula, the asset’s price in a
risk neutral world. The second term is a risk adjustment. An asset whose payoff covaries
positively with the discount factor has its price raised and vice-versa.

To understand the risk adjustment, substitute back for 𝑚 in terms of consumption, to

obtain

𝐸(𝑥) 𝑐𝑜𝑣[𝛽𝑢′ (𝑐𝑡+1 ), 𝑥𝑡+1 ]

𝑝= + .
𝑅𝑓 𝑢′ (𝑐𝑡 )

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 Marginal utility 𝑢′ (𝑐𝑡 ) declines as 𝑐 rises. Thus an asset’s price is lowered if its payoff
covaries positively with consumption, and vice-versa.

Why?

• Investors do not like uncertainty about consumption. If you buy an asset whose payoff
covaries positively with consumption, one that pays off well when you are already
feeling wealthy, and pays off badly when you are already feeling poor, that asset will
make your consumption stream more volatile. You require a low price to induce you to
buy such an asset.

• If you buy an asset whose payoff covaries negatively with consumption, it helps to
smooth consumption and so is more valuable than its expected payoff might indicate,
e.g. insurance.

b) What exactly is meant by the statement that stock prices are ‘excessively
volatile’? Is this a testable proposition? [8 Marks]

• ‘excessively volatile’, it must be relative to some benchmark. That is, there must
be some criterion against which to assess whether or not prices are too volatile.
[1 Mark]

• This criterion or benchmark is provided by a model of stock prices. Now confront

the issue of which model should be used as a benchmark for price volatility. [1
Mark]

• Proceed to propose a good model e.g. that proposed by Shiller. Shiller’s approach
is based on the ‘dividend discount models’ which propose that asset prices should
be equal to the net present value of the future stream of returns. [1 Mark]

• Illustration of Shiller’s model for testing excessive volatility. [2 Marks]

• Briefly highlight model criticism. Criticisms of Shiller’s approach: technical,

substantive, interpretational [3 Marks – 1 Mark for each]

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QUESTION FOUR

a) Derive the Equity Risk Premium assuming an investor exhibits an iso-elastic utility
function. How can your derivation be used to show the existence of the Equity
Risk Premium Puzzle. [5 Marks]

Manipulating the FVR can expose the EPP

𝐸[(1 + 𝑟𝑗 )𝐻] = 1 (1)

Choose two assets, equity, with rate of return 𝑟𝑒 and bonds with rate of return, 𝑟𝑏 . Hence

𝐸[(1 + 𝑟𝑒 )𝐻] = 1

(2)

𝐸[(1 + 𝑟𝑏 )𝐻] = 1

(3)

𝐸[(𝑟𝑒 − 𝑟𝑏 )𝐻] = 0

(4)

Now, under the assumption of iso-elastic utility in the intertemporal consumption and
portfolio selection model, (4) becomes,

𝛿𝐸[(𝑟𝑒 − 𝑟𝑏 )(1 + 𝑐)−𝛾 ] = 0

(5)

where 𝑐 ≡ (𝐶𝑡+1⁄𝐶𝑡 ) − 1 denotes the rate of growth of consumption. Similarly, (3) can be
written as,

𝛿𝐸[(1 + 𝑟𝑏 )(1 + 𝑐)−𝛾 ] = 1

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 (6)

The EPP asserts that the value of 𝛾 needed to satisfy 𝛿𝐸[(𝑟𝑒 − 𝑟𝑏 )(1 + 𝑐)−𝛾 ] = 0 in the data is
much larger than values of 𝛾 estimated in other contexts (which focus on measuring 𝛾 as an
index of risk aversion). While there is no consensus about the exact magnitude of 𝛾 obtained
in these other models, many studies favour a value less than three. This is much lower than
estimates obtained from using sample averages to represent expected returns, and the
average rate of growth per capita consumption for 𝑐 in 𝛿𝐸[(𝑟𝑒 − 𝑟𝑏 )(1 + 𝑐)−𝛾 ] = 0.

b) State and derive the variance bound used in the excess volatility literature. What
is the implication of the variance bound? [6 Marks]

Var(P*t)=Var (Pt)+Var(Ut)+2cov (Pt,U)

= Var(Pt)+ Var(Ut)

since Cov(Pt,U)=0

Given that Var Ut > 0, implies immediately that Var Pt < Var P*t

Equivalently,

s.d(Pt) < s.d(P∗t) This inequality asserts formally that the variability (volatility) of a
forecast, Pt , must be less than that of its target, P*t so long as the error, Ut , is
uncorrelated with the forecast itself.

c) Discuss the role of informational asymmetries in determining bid-ask spreads in

stock markets. [9 Marks]

• Positive bid-ask spreads originate from either (a) inventory holding costs or
(b) information asymmetries. Assume that inventory holding costs can be
ignored.

• Consider a world with informed investors, uninformed investors and dealers.

Assume that traders arrive sequentially at the dealers’ desks and the dealers
cannot distinguish between informed and uninformed investors. Dealers are
assumed to have the same information as uninformed investors and to be
perfectly competitive with one another.

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 • Dealers make losses whenever they trade with informed investors. When
dealers trade with uninformed investors, on average they make zero profits.
Hence, dealers can survive only by setting their ask price higher than their
bid price: they buy from investors at a lower price than at which they sell.

• Thus the non-zero bid-ask spread involves, profit for the informed investors,
zero expected profit for the dealers and negative expected profit for the
uninformed investors (who may be trading for reasons unrelated to
information, for example, to obtain cash for consumption).

• Glosten and Milgrom show that the transaction price evolves according to a
martingale. As dealers observe the pattern of trades, they update their
beliefs about the underlying value of the asset. Eventually, asset prices
reflect the information known to the informed traders. Hence, the asset
market is strong form efficient but only as an approximation, i.e. in the limit
as time tends to infinity.

• If the information is “too asymmetric” — in the sense that there are too many
informed investors relative to uninformed investors—then the market may
break down altogether. Informed investors always make a profit from the
dealers, who (in order to survive) may have to widen the spread so much that
no-one wishes to trade.

QUESTION FIVE

a) Finance literature has taken three key directions in explaining the Equity Risk Premium,
namely, (1) heterogenous agents, (2) non-standard preferences, and (3) estimation
uncertainty. Briefly discuss any two of these explanations of the Equity Risk Premium
Puzzle. [8 Marks]

Heterogeneous agents:

• Involves incorporation of the life-cycle feature in asset pricing. Suppose

Consumption = wages + equity income

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 • The authors argue that the young are characterized by low wages hence the need
to borrow to invest in equities.

• Borrowing constraints – adverse selection and moral hazard (human capital

inadequate to collateralize major loans).

• Equities are then exclusively priced by the middle aged who demand higher
returns hence a higher premium.

Non-standard preferences

• Some scholars argue that individuals preferences and hence their decisions are
flawed and not the model.

• Evidence could be understood to imply that individuals are irrational.

• External habit formation - Utility is defined relative to average per capita

consumption.

• Internal habit formation - Utility is affected by both current and past

consumption.

Estimation uncertainty

• Reliance on a single historical sample of data could lead to inaccurate estimates

of the stochastic discount factor and the coefficient of risk aversion.

• This may lead to incorrect inferences.

• Where assumptions are flawed, predictions deviate from evidence.

• Relaxing some of the assumptions may resolve the puzzle

b) One of the widely applied models in traditional finance is valuation based on the
𝑫𝟏
canonical Constant Growth Model of the form 𝑷𝟎 = 𝑲 where 𝑷𝟎 is the estimated
𝒆 −𝒈

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 current stock price, 𝑫𝟏 is the dividend one year ahead, 𝑲𝒆 is the cost of equity and 𝒈 is
the constant growth rate in dividends.

Discuss, using proper decomposition of the components of the model, the problems that
could arise from using the model in applied work. Offer suggestions on how to deal with
some of the issues raised. [12 Marks]

A solid response to this question will expand the equation above and discuss the various
puzzles, hence unfinished business or inconclusive aspects of each of the components.

• Dividend puzzle of Meyer Stewart 1976;

• Equity Premium Puzzle of Mehra & Prescott 1985;

• Risk Free Rate Puzzle; and

• Size Puzzle affecting the constant growth rate assumption.

• In addition problems arise due to the assumption that r>g and that r is constant such
that there exists a unique solution for the price.

Modelling assumptions

• Use of multistage DDM where there are high growth rates;

• Application of the model requires hindsight of the assumptions and the theoretical and
empirical problems of the inputs. As such analyst and expert judgment is required in
applying the model.

• The model should be used with adjustments to suit the situation and where not
applicable alternative approaches to estimating terminal values should be explored;

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