Session 11

CAPM Extensions

Session
Outline

Session Outline

• CAPM without a riskless asset

• Merton’s intertemporal CAPM

• Other extensions of the CAPM

¾ CAPM with heterogeneous beliefs

¾ CAPM and taxes

2
 CAPM without a
riskless asset I

CAPM without a riskless asset

• We know that if no riskless asset is available, the

efficient frontier is no longer linear.

• But Black (1972) showed that the main CAPM asset

pricing relation (“beta pricing”) continues to hold:

E( R j ) E( RZ )  E j > E( RM )  E( RZ )@

• Key change: replace the riskless asset by the “zero-beta

portfolio on the efficient frontier”, Z.

CAPM without a
riskless asset III

• To obtain the asset pricing relationship we impose

tangency at the market portfolio:
(5

&DSLWDOPDUNHWOLQH

(50 0DUNHW
SRUWIROLR

(IILFLHQWIURQWLHU

E(RZ)

=HUR%HWD
SRUWIROLRV
V5
V(RZ) V(RM) 4
 CAPM without a
riskless asset IV

CAPM without a riskless asset

• A zero-beta portfolio is characterized by a payoff with

zero correlation to the market payoff.

• If the CAPM relation holds, all zero-beta portfolios

must have the same expected return.

• This expected return is identified by the line tangent to

efficient frontier at the market portfolio M.

CAPM without a
riskless asset V

CAPM without a riskless asset

• Portfolio optimization by investors implies that the

market portfolio always is on the efficient frontier.

• By combining the market portfolio and the zero-beta

portfolio on the efficient frontier, we can obtain any
frontier portfolio.

• We derive the beta-pricing relation by starting from the

definitions of expected return and standard deviation of
any frontier portfolio P.

6
 CAPM without a
riskless asset VI

Risk-return tradeoff without a riskless asset

­ E( RZ ) for D 0
E( Rp ) D E( RM )  (1  D )E( RZ ) ®
¯E(RM ) for D 1
­V Z for D 0
V ( Rp ) D 2V M
2
 (1  D )2V Z2 ®
¯V M for D 1
• Taking the derivative with respect to the weight D:
dE( Rp )
E(RM )  E( RZ )
dD
dV ( Rp ) 2
DV M  (1  D )V Z2
V M for D 1
dD D 2V M
2
 (1  D )2V Z2
7

CAPM without a
riskless asset VII

Risk-return tradeoff without a riskless asset

• Evaluating at D = 1, we obtain the slope of the efficient

frontier at the market portfolio:

dE( Rp ) dE(Rp ) / dD E( RM )  E( RZ )
dV ( Rp ) dV ( Rp ) / dD VM

• This slope and the expected return on portfolio Z define

the “capital market line”:
E( RM )  E( RZ )
E( Rp ) E( RZ )  Vp
VM
8
 CAPM without a
riskless asset VIII

Risk-return tradeoff without a riskless asset

• Now we show that the expected payoff of any asset j

can be expressed as a linear combination of the
expected payoffs of the market portfolio and the zero-
beta portfolio.

• Start from the portfolio:

E( Rp ) D E( RM )  (1  D )E( R j )

V (Rp ) D 2V M
2
 (1  D ) 2 V 2j  2D (1  D )V jM

CAPM without a
riskless asset IX

Risk-return tradeoff without a riskless asset

2
dV ( R p ) DV M  (1  D )V 2j  (1  2D )V jM
dD D 2V M
2
 (1  D )2 V 2j  2D (1  D )V jM
2
dV ( Rp ) V M  V jM
• Evaluating at D = 1 again:
dD VM

• So the risk-return tradeoff at D = 1 is:

dE( Rp ) dE( Rp ) / dD E(RM )  E( R j )

dV (Rp ) dV ( Rp ) / dD 2
VM  V jM
VM
10
 CAPM without a
riskless asset X

Risk-return tradeoff without a riskless asset

• Equating the two tradeoffs:

E( RM )  E(RZ ) E(RM )  E(R j )
VM
VM 2
VM  V jM
2
VM  V jM
E(R j )  E( RM )
2
> E(RZ )  E(RM )@
VM
(1  E jM ) > E(RZ )  E( RM )@

Ÿ E( R j ) E( RZ )  E jM > E( RM )  E( RZ )@

11

CAPM without a
riskless asset XI

When is this extension of the CAPM relevant?

• A fundamental assumption of this model is that short-

selling of risky assets is possible, because almost all
existing assets have positive beta.

• If no riskless asset is available and short-selling of risky

assets is not possible, the CAPM asset pricing relation
no longer holds.

12
 CAPM with log-
normal prices I

CAPM with log-normal prices

• A problem with the normality assumption is that under

this assumption asset prices can be negative.
• This problem does not arise if asset prices are log-
normal, i.e. if ln(P) is normally distributed.
• Suppose that:
(i) prices are log-normally distributed (thus returns are
normally distributed),
(ii) investors’ preferences are strictly concave,
(iii) there is continuous trading.
Then according to the continuous-time model by Merton
(1973), preferences have a mean-variance representation.
13

CAPM with log-

normal prices III

CAPM with log-normal prices

• The investor maximizes discounted expected utility by

choosing consumption c(t) and portfolio shares wj(t):
f
V0 max E0 ³ eG su(c(s))
c(t ), w j (t ) s 0
• The budget constraint is:
N 1 dPj (t )
dW (t ) ¦ w j (t )W (t )  c(t )dt,
j 1 Pj (t )
where wj(t) is the fraction of wealth invested in asset j at
time t.
14
 CAPM with log-
normal prices IV

CAPM with log-normal prices

• Asset prices are assumed to follow a geometric

stochastic process with drift which implies log-normal
prices:
dPj (t )
a j dt  V j dz j ,
Pj (t )
where Dj and Vj are asset-specific parameters
determining the mean and variance of returns.

• dz denotes a Brownian motion which is a continuous-

time stochastic process that behaves like a random walk.
15

CAPM with log-

normal prices V

CAPM with log-normal prices

• The price processes might be correlated and the

elements of the instantaneous covariance matrix of
returns : are given by:

Vij V iV j Uij ,

where Uij is the correlation between the innovation

processes dzi and dzj.

• The model is solved by finding the function V*(W(t))

that solves the Bellman-equation.

16
 CAPM with log-
normal prices VI

CAPM with log-normal prices

• The optimal portfolio shares of investor k are given by:

N
w*j Ak ¦ vij (D j  r ),
i 1
where Ak is the investor’s risk tolerance, each vij is an
element of :-1, and r is the instantaneous riskless rate.

• These portfolio shares are equivalent to those implied

by a myopic investor with mean-variance preferences.

17

CAPM with log-

normal prices VII

CAPM with log-normal prices

• Identically to the CAPM, the equilibrium asset pricing

relation is therefore also given by:

E(ri ) r f  Ei [E(rM )  r f ],

where the betas are defined as usual.

• Again, the equilibrium expected returns depend on the

covariance of the asset with the market return and the
market risk premium.

18
 CAPM with log-
normal prices VIII

CAPM with log-normal prices

• Merton’s intertemporal CAPM can price assets also if

there is uncertainty about the future instantaneous riskless
rate.

• In this case, the equilibrium asset pricing relation

becomes:
E(ri ) rf  J1[E(rM )  rf ]  J 2[E(rN )  rf ],

where rN is the return on a portfolio that is perfectly

negatively correlated with the instantaneous interest rate.

19

CAPM with log-

normal prices IX

CAPM with log-normal prices

• This result has been called “three fund separation”.

• There is a relationship between the J’s and the beta of

the traditional CAPM:

E jM  E jN E NM
J1 , The higher is a stock’s EjM,
1  UNM the larger is J1 (sensitivity
to market risk) and the
smaller is J2 (sensitivity to
E jN  E jM E NM interest rate risk).
J2 .
1  UNM

20
 CAPM and
heterogeneity

Heterogeneous expectations

• Lintner (1969) showed that the CAPM asset pricing

relation is robust to the introduction of heterogeneous
subjective probabilities of payoff realizations.

• Heterogeneity in S means that the market expectation

used to compute the relevant expected payoffs and
covariances becomes a function of these probabilities.

• But in this case the market portfolio is no longer

necessarily efficient.

21

CAPM and taxes

Capital gains and dividend taxes

• Brennan (1970) produced another two-factor model of

expected returns based on the assumption of different
taxation of capital gains and dividends.

• The CAPM asset pricing relation then becomes:

Dj
E(ri ) J1rf  J 2E j  J 3 ,
Pj
with J3 > 0 if capital gains are taxed less than dividends.

• Intuitively, investors must be compensated for the

higher taxes they pay on distributed dividends.
22
 Session 12

Testing the CAPM

Session
Outline

Session outline

• Testable implications of the CAPM

• Roll critique

• Testing methodology

• Empirical results
 Testing the CAPM I

Testable implications of the CAPM

• The fundamental relation implied by the CAPM is:

E ( R jt ) R ft  E j ª¬ E ( RMt )  R ft º¼ (1)

• This is called the “ex ante” form of the CAPM because

expected returns are used.

• Expected returns are not empirically observable and this

form is therefore not testable.

• Assuming rational expectations we can replace expected

returns by their realized values plus an error term.

Testing the CAPM II

Market model

• Assume that returns are generated by a statistical

process with a single common (market) factor:
R jt E( R jt )  E jG Mt  H jt (2)

RMt E( RMt )  G Mt (3)

where E(GMt) = E(Hjt) = 0, E(GMtHjt) = 0, E(GMtGMt-W) = 0

and E(HjtHjt-W) = 0 .

• Substitute E(Rjt) from (1):

R jt R ft  E j ª¬ RMt  R ft º¼  H jt
 Testing the CAPM
III

Empirical specification of the CAPM

• For empirical testing, the market model is written in

terms of excess returns:

R jt  R ft E j ª¬ RMt  R ft º¼  H jt

• Ex post, the slope of the security-market line depends

on the realization of the market excess return and can
therefore be negative.

• Instead it is positive in the ex-ante form.

Testing the CAPM

IV

Ex-ante and ex-post versions of the CAPM

E(Rj) Rj
CAPM: ex ante CAPM: ex post

Rft

E(RM)

RMt Ej

Rf

 Ej
 Testing the CAPM V

Empirical tests of the CAPM

• Estimate the equation implied by the ex-post CAPM:

R jt  R ft J  Ot E j  H jt

• Test the null hypotheses implied by the CAPM:

 J is equal to 0,
Ej is the only factor explaining excess returns (other
variables must not have significant coefficients),
3) the relationship is linear,
 Ot is equal to RMtRft Ÿ over long horizons Ot > 0, as
the risk premium on the market must be positive.

Roll critique I

Roll critique

• Roll (1977) pointed out that testing the CAPM requires

observations of the entire portfolio of risky assets held
by households.

• This includes housing wealth, bonds, non-traded

business equity, human capital and other assets.

• But almost all empirical implementations rely on a less

inclusive proxy for the market portfolio.

• Popular choices are broad, value-weighted or equally-

weighted stock indices.
 Roll critique II

Roll critique

• Discovering a rejection of the CAPM-implications using

a market return proxy then does not imply that the
CAPM is necessarily wrong.

• It might just be that the market proxy does not capture

adequately the market portfolio.

• Also, not rejecting the CAPM-implications using a

market proxy does not imply that the CAPM is correct.

• Therefore the CAPM is not testable according to Roll.

Roll critique III

Roll critique

• Stambaugh (1982) showed that empirical results are

similar for market proxies based on stocks only, stock
and bonds and stocks, bonds and real estate.

• But private equity holdings and human capital should

also affect portfolio choice and asset pricing.

• The Roll critique therefore continues to be relevant.

 Empirical
methodology I

Time series regressions

• A popular way of testing the CAPM is to use time series

of market and individual asset excess returns to estimate
for each individual asset j:
R jt  R ft J j  Ot E j  H jt

• The relevant implication of the CAPM to be tested is:

H 0 : Jˆ j 0, for all j.

• Assuming joint normality of returns, OLS can be used

for estimation.

Empirical
methodology II

Time series regressions

• For each individual a t-test is appropriate.

• But we would like to know whether the entire vector of

intercepts is close to zero.

• If the errors are uncorrelated and homoskedastic, the

relevant test-statistic has an exact F-distribution:

6ˆ E  Hˆt Hˆt '

 Empirical
methodology III

Time series regressions

• Without the normality assumption, we can obtain an

asymptotic test, valid as t goes to 4.

• If the errors are uncorrelated and homoskedastic the

relevant test-statistic has an asymptotic F2-distribution:
1
ª § E ( R  R ) ·2 º
T «1  ¨
Mt ft
¸ » Jˆ ' 6ˆ 1Jˆ  F N2 6ˆ E  Hˆt Hˆt '
« ¨© Vˆ ( RMt  R ft ) ¸¹ »
¬ ¼
• This test is equivalent to a test on the joint significance
on asset dummies in a panel regression context.

Empirical
methodology IV

Time series regressions

• With heteroscedasticity and cross-correlation estimation

should be done by GMM rather than OLS, and again the
relevant test statistic has an asymptotic F2-distribution.

• The moment conditions are given by:

ª
«

ET  R jt  R ft   O j  E j  RMt  R ft   º
» 0
«¬ ¬
T 
«E ª R  R  O  E R  R
 jt ft  j j  Mt ft  RMt  R ft  º»
¼ »¼
• The test statistic becomes simply:
 Empirical
methodology V

Cross-sectional regressions

• An alternative procedure relies on a two-step procedure

to estimate:

R jt  R ft J  OE j  H jt

– Estimate the betas from time series regressions of

individual asset returns on the market return.

– Run cross-sectional regressions of returns on beta’s

for subsequent periods.

• Finally, test the significance of J.

Empirical
methodology VI

Cross-sectional regressions

• The correct estimation procedure for the time series

regressions is OLS.

• The cross-sectional regressions should be run with GLS

because errors are likely correlated with each other.

• The relevant test statistic is asymptotically F2:

T Jˆ ' 6ˆ  1Jˆ  F N2 1
6ˆ E  Hˆt Hˆt '
 Empirical
methodology VII

Cross-sectional regressions

• Since the betas are estimated, cross-sectional estimates

are subject to an error-in-variables problem.

• So, the standard errors of the coefficient estimates must

be adjusted to reflect this additional variation.

• Assuming that the errors of the cross-sectional regression

are i.i.d. and independent of the market factor, the
corrected test statistic is:
T 1  O 'Var ( RM  R f ) 1 O  Jˆ ' 6ˆ 1Jˆ  F N2 1

Empirical
methodology VIII

Cross-sectional regressions

• These corrections tend to have a large effect on

estimates and test outcomes.

• With more general errors, the cross-sectional

regressions should be run with a GMM procedure .

• The moment conditions are:

ª
«

ET  R j  R f   D j  E j  RM  R f   º
»
« ¬T 
«E ª R  R D  E R  R
j f  j j  M f  RM  R f  º»
¼»
0
« »
«¬ E 
T  j
R  R f   E j O  »¼
 Empirical
methodology IX

Cross-sectional regressions

• The test statistic remains the same and continues to be

asymptotically F2 distributed.

• But the estimate of the variance-covariance matrix of

the residuals is more complicated now.

• In general, this estimate depends on all leads and lags of

the residuals.

Empirical
methodology X

Fama-MacBeth method

• Fama-MacBeth have suggested a refinement to reduce

the estimation error in the betas.

• They first estimate betas based on individual returns,

then group the stocks to broad portfolios based on these
estimates and re-estimate betas for these portfolios.

• An advantage of this procedure is that if the betas are

tightly estimated one can better test for the explanatory
power of other factors.
 Empirical results I

General findings

• In the recent years, various studies have found that

factors like market capitalization, price-earnings ratio
and book value to market value-ratio help explain
excess return variation.

• Some studies also find a seasonality in excess returns

(January effect) and a momentum effect (high returns in
the recent past impacts positively on returns).

• Empirical results of this kind are also called “pricing

anomalies”.

Empirical results II

General findings

• The empirical verifications of the CAPM generally

show that J is not significantly different from 0.

• Also the estimated slope (RM  Rf) in the cross-sectional

regressions is often lower than the difference calculated
from raw data.

• A linear model specification seems to be appropriate.

• Based on these empirical results, the standard version of

the CAPM should be rejected.
 Empirical results III

Possible explanations

• Currently there is no alternative theory available that

explains these departures from the CAPM implications.

• Also, it is quite possible that the CAPM is true, but the

empirical procedure is not adequate.

• First, all empirical procedures use a proxy for the

market portfolio (Roll-critique).

• Second, some additional explanatory factors should

by chance have explanatory power (data snooping).

Empirical results IV

Possible explanations

• Third, selection bias due to firms being delisted from

equity markets or going bankrupt could bias results in
favor of rejection of the CAPM.
 Session 13

Arbitrage Pricing Theory

Session
Outline

Session Outline

• Concept of arbitrage

• Assumptions: market model

• Derivation with two risky assets

• General derivation

• Empirical implications

• Relationship to the CAPM

2
 Definitions I

Definition of Arbitrage

• Recall the definition of arbitrage given earlier in the

course:

“An arbitrage portfolio is a portfolio h with a non-

negative payoff vector and a non-positive price.”

• Ross (1976) introduced a theory of asset pricing based

on the absence of arbitrage.

• The theory relies heavily also on the absence of short-

selling restrictions.
3

Definitions II

Definition of Arbitrage

• Very intuitive in the case of certain payoffs:

If two riskless assets have the same price but different

payoffs, the optimal strategy is an arbitrage with infinite
profits:

“Short-sell an infinite amount of the low payoff asset

and buy an infinite amount of the high payoff asset.”

• But the concept can be extended to uncertain payoffs:

recall the diagram…

4
 Arrow securities V

No arbitrage:
(p1, p2)

$VVHW
x.1

x.2

x.3

$VVHW

3RVLWLYHSD\RIIV
3RUWIROLRVZLWK
QHJDWLYHSULFH

5
=HURSULFHSRUWIROLRV

Definitions IV

Assumptions of APT

• Arbitrage Pricing Theory (APT) rests on 3 assumptions:

– The return process has a linear factor structure:

M
R j E ( R j )  ¦ E ji ( fi  E ( fi ))  H j .
i 1
– A well-diversified portfolio P without idiosyncratic
and systematic payoff risk exists.

– There are no arbitrage portfolios.

6
 Market model I

Market Model

• One example of the theory is the “market model”:

Rj E ( R j )  E j ( R M  E ( RM ))  H j .

• This is a single-factor model with the market return

being the only factor generating a market risk-premium.

• To simplify the model, we will now assume that the

non-priced return risk Hj is exactly zero for all assets.

Market model II

Market Model

• Then we get R j  E ( R j ) E j ( R M  E ( RM )).

• With only two assets, i and j, we can form a portfolio Rp
without systematic payoff risk.

• The return of this zero-beta portfolio is

Rp aR j  (1  a) Ri
a[ E ( R j )  E j ( R M  E ( RM )]
(1  a)[ E ( Ri )  Ei ( R M  E ( RM )].
where the weight a is such that a E j  (1  a) Ei 0.
8
 Market model III

Market Model

• With no systematic risk and idiosyncratic risk assumed

away, the return on this portfolio must be the riskless
rate to avoid arbitrage:

E(Rp ) aE ( R j )  (1  a) E ( Ri ) Rf .
• 2 equations:
a[ E ( R j )  R f ]  (1  a)[ E ( Ri )  R f ] 0,
aE j  (1  a) Ei 0.
E(R j )  R f E ( Ri )  R f
Solution requires: O.
Ej Ei
9

Market model IV

Market Model

• Therefore:
E(R j ) R f  E jO,

E ( Ri ) R f  Ei O .

• Defining as RM the return of a portfolio with E = 1, we

can substitute out O, and obtain the CAPM relationship:

E(R j ) 
R f  E j E ( RM )  R f . 
10
 Market model V

The Security Market Line again…

E(Ri)
E(R2) Asset 2

Asset 3
E(R12)

Asset 1
E(R13)

Ei
E1 E2 E3

• Unsurprisingly, we also recover the basic empirical

implication of the CAPM that all Di’s are zero. 11

Two factors, three

assets I

Two risk factors

• If there are 2 risk factors, the return-generating process is:

R j  E ( R j ) E j1  RM 1  E ( RM 1)   E j 2  RM 2  E ( RM 2 )  .

• The portfolio without systematic risk now requires 3

assets h, i and j with portfolio weights such that:

wh Eh1  wi Ei1  w j E j1 0
wh Eh2  wi Ei 2  w j E j 2 0

wh  wi  w j 1
12
 Two factors, three
assets II

Two risk factors

• The solution of the system of equations

ª E ( Rh )  R f E ( Ri )  R f E(R j )  R f º ª0 º
« » ª wh º «0 »
« E h1 Ei1 E j1 »« »
wi » « »
« Eh2 Ei 2 E j2 » « «0 »
« » ¬« wj ¼» « »
« » ¬1 ¼
¬ 1 1 1 ¼
exists if the 1st eq. is a combination of the 2nd and the 3rd:
E ( Rh )  R f E h1O1  E h 2O2 ,
E ( Ri )  R f Ei1O1  Ei 2O2 ,
E(R j )  R f E j1O1  E j 2O2 ,
13

Two factors, three

assets III

Two risk factors

• These O’s are the risk premia associated with the two
risk factors.

• Define as follows the returns of portfolios with Ejf= 1

for factor f = 1, 2 only (E being zero for the other):

E ( RM 1 )  R f O1, E ( RM 2 )  R f O2 .

Then, we obtain another asset pricing equation:

E(R j )   
R f  E j1 E ( RM 1 )  R f  E j 2 E ( RM 2 )  R f . 
14
 One factor, N assets I

Non-systematic risk

• Assuming that non-systematic risk Hj is uncorrelated

across assets, we can call this risk “idiosyncratic”:

Rj E ( R j )  E j ( f  E ( f ))  H j .

• A well-diversified portfolio Rw has no idiosyncratic risk:

Rw w 'R w ' E (R )  w ' ( f  E ( f ))  w ' 

| w ' E (R )  w ' ( f  E ( f ))

E ( Rw )  w ' ( f  E ( f ))
15

One factor, N assets

II

Non-systematic risk

• The last result is an application of the law of large

numbers which holds asymptotically as N goes to 4.

• We can again find a portfolio without systematic risk by

using weights w such that

w ' 0.

• By the absence of arbitrage then we must have:

E ( Rw ) w ' E (R ) Rf .
16
 One factor, N assets
III

Non-systematic risk

• The system of 3 equations ª ª¬ E (R )  R f  N º¼ 'º ª0º

« »
« ' »w «0»
« » « »
«¬  N ' »¼ «¬1 »¼

has multiple solutions, since N >> 3. So we can create

several such portfolios with one risk factor, as in the case
examined initially (with such portfolios replacing assets)!

• Again, the excess returns of each such portfolio must

be proportional to its beta:

E(R j ) R f  E jO Ÿ R j  R f E j (O  f  E ( f )) 17H j

APT I

General case

• Turn to the case of M risk factors and N assets with

idiosyncratic risk. The return of asset j is :

R j =E(R j )  E j1[ f1  E( f1)]  ...  E jM [ fM  E( fM )]  H j

• We can form M + 1 diversified portfolios (indexed by w

= 1,2, …, M + 1) with no idiosyncratic risk (w'HH | 0):

Rw w'E(R)  w'1[ f1  E( f1)]  ...

 w'M [ f M  E ( f M )]  w'

E(Rw )  Ew1[ f1  E( f1)]  ...  EwM [ fM  E( fM )]

18
 APT I

General case

• Now we can combine the M +1 portfolios so as to

obtain a portfolio immunized against all M risk factors:

M 1 M 1
¦ ww E w1 w ' 1 0, ... , ¦ ww E wM w ' M 0.
w 1 w 1

• The resulting portfolio (call it Z) is risk-free:

Ÿ RW w'E(R)  w'1[ f1  E( f1)]  ...

 w'M [ f M  E ( f M )] Rf
19

One factor, N assets

III

General case

• This generates a system of M + 2 equations with M + 1

unknown weights:
ª ª E ( R )  R f  N º 'º ª0º
«¬ ¼»
«0»
« 1 ' » « »
« » w «...»
« ... » « »
« M ' » «0»
« » «¬ 1 »¼
¬«  N ' ¼»
• Again, the excess returns of each component portfolio
must be proportional to its beta:
E ( Rw )  R f E w1O1  ...  E wM OM .
20
 APT II

General case

• As in the 2-factors case, we can interpret the O’s as the

risk premia associated with the various factors.

• Considering portfolios that are perfectly correlated with

exactly one factor i, but uncorrelated with all others:

E ( Ri )  R f Ei1O1  ...  E
Nii Oi  ...  EiM OM Oi .
=1

Ÿ E ( Rw )  R f E w1[ E ( R1 )  R f ]  ...  E wM [ E ( RM )  R f ].

21

APT III

General case

• Excess returns are then in general given by

M
Rj  Rf ¦ E ji [Oi  fi  E( fi )]  H j
i 1

and if the factors are portfolios by

M
E(R j )  R f ¦ E ji [E(Ri )  R f ]
i 1

• The risk factors (fi – E(fL) + Oi) are orthogonal to each

other and to the disturbances Hj.
22
 Empirical
implications I

Empirical implications

• It might even be the case that a few assets are not priced
correctly, but the weight of these assets in all well-
diversified portfolios has to be small.

• The main issue in empirical implementation of the APT

is the choice of risk factors.

• To apply the theory, observed returns are used to find the

fundamental risk factors present in the market and those
factors are then used to price other assets.

23

Empirical imlications
II

Empirical implications

• This procedure yields risk factors that are determined by

statistical criteria only.

• Purely statistical risk factors do not yield uniquely

identified risk premia: there always exists an idempotent
transformation matrix G that converts risk factors and
factor loadings preserving their orthogonality.

• Furthermore, the risk factors might be difficult to

interpret theoretically and unstable across samples.

24
 Empirical
implications III

Empirical implications

• In this sense, the generality of the APT is a weakness and

more structural approaches yield more intuitive and
stable results.

• An alternative approach is to choose risk factors that

theoretically should carry a market risk premium such as
macroeconomic risk factors, liquidity risk factors, etc.

• Chen, Roll and Ross (1986) have isolated five factors that
influence excess returns systematically.

25

Chen, Roll and Ross

Empirical results I

• These factors are:

- industrial production,

- yield spread between low & high risk corporate bonds,

- yield spread between short & long-term interest rates,

- unexpected inflation,

- changes in expected inflation.

26
 Chen, Roll and Ross
Empirical results I

• The paper finds that adding the market excess return to

the asset pricing equation does not explain returns better.

• These factors are expected to affect discount factors and

expected returns in an equilibrium model and therefore
can also be given a theoretical interpretation.

27

Fama and French

Empirical results II

• Fama and French (1993) have provided another popular

multi-factor model based on two factors.

• Their factors are excess returns of portfolios constructed

on the basis of book-to-market ratio and firm size.

• They show that market beta does not help explain

variation in excess returns when added to size and book-
to-market ratio.

28
 Relationship to CAPM
Empirical results III

• APT provides a much more flexible theoretical basis for

empirical work in asset pricing than the CAPM.

• APT would be equivalent to the CAPM, if the market

portfolio betas were the only significant variables in an
excess return equation.

• The results just reported strongly suggest that the

standard CAPM fails empirically.

29

Session 14

Consumption-Based Asset Pricing I

 Session
Outline

Session Outline

• Motivation

• Lucas model

• Consumption betas

• Testing the CCAPM

• Scaled payoffs

CAPM problems I

Motivation

• The CAPM implied three main propositions that have

been contradicted by recent empirical work:

– Market beta is the only factor explaining the cross-

sectional variation in expected stock returns.

– Time-series variation in returns is unpredictable.

– Active portfolio management harms investors: it

creates costs without offsetting benefits.
 CAPM problems II

Empirical failures of CAPM

• Many empirical results instead suggest that:

– The variation in expected returns is explained by

market returns plus macroeconomic and firm-
specific factors.

– Long-term returns on stocks, bonds and foreign

exchange are predictable.

– Volatility and risk premia change over time in a

predictable way.

CAPM problems III

Explore new directions

• These empirical findings have led researchers to explore

more complex models of financial markets.

• Consumption-based models are dynamic: they allow for

time-varying discount factors and risk premia.

• They link the financial market to the real economy by

modeling it as part of a general equilibrium.

• Within a consumption-based model risk factors can be

better interpreted theoretically.
 Lucas model I

Lucas model

• The first model of this kind was the Lucas (1978) asset
pricing model (fruit tree model).

• The Lucas model showed that in a representative agent

economy asset prices do not follow a martingale if the
period utility function of the agent is strictly concave.

• The model also showed that the appropriate discount

factor used to price assets should be based on the
covariances of returns with aggregate consumption.

Lucas model II

Representative agent

• The representative agent is assumed to have rational

expectations and to maximize a discounted sum of
strictly concave utility functions:

ªf t º
max V0 E0 « ¦ E u (ct ) »
f
^ `
ct t 0 ¬t 0 ¼

by choosing optimally at each date t a consumption

level {ct} and share holdings {zjt+1} to be held in the
subsequent period, for each share j (for j = 1, …, N).
 Lucas model III

Output

• Frictionless trading is possible in each period.

• Each “tree” is represented by a single share that entitles

the holder to all the output produced.
• The population is standardized to 1. So is the number of
“trees” of each variety j.
• Output cannot be stored, is exogenous and stochastic, and
its law of movement is defined by a Markov process:

F (d ', d ) prob(d jt 1 d d ' d jt d)

Lucas model IV

Budget constraint

• The budget constraint relates output, consumption and

financial investments by the representative agent:

 
N
ct ¦ d jt z jt  p jt z jt  p jt z jt 1
j 1
where pt is the price of a share in period t and zjt d 1.

• With 1 share (“tree”) of each type and 1 investor, in

equilibrium he will hold all the N shares and be entitled
to the corresponding output: there will be no trade.
 Lucas model V

No-trade equilibrium

• Market clearing requires that at each date:

™ The output (= dividends) of all “trees” (= shares) is

consumed: N
ct ¦ d jt { dt ,
j 1
where dt is a shorthand for the total dividend flow.

™ All N shares are held:

z jt 1, for j 1,..., N .

Lucas model V

Optimality condition and equilibrium price

• We have N first-order conditions for optimal portfolio

choice, one for each share holding zjt:

u '(ct ) p jt Et ª¬ E u '(ct 1 )(d jt 1  p jt 1 ) º¼ . (1)

• To find the equilibrium price one recursively substitutes

this relation to get
ª f u '(ct  s ) º
p jt Et « ¦ E d jt  s » (2)
¬ s 1 u '(ct ) ¼
and one imposes ct = dt for all t.
 Lucas model VI

Consumption betas

• Hence, the appropriate discount factors for valuation of

risky assets are related to the marginal utility of
investors rather than the payoff of the market portfolio.

• We can derive an asset pricing equation by substituting

the definition of returns:
d jt 1  p jt 1
1  r jt 1 {
p jt 1
into the first-order condition (1):
ª u '(ct 1 ) º
1 Et « E (1  r jt 1 ) » . (1')
¬ u '( ct ) ¼

Lucas model VII

Consumption betas

• If a risk-free asset existed, its price would then be

defined by:
1 ª u '(ct 1 ) º
E Et « ». (3)
1  r ft 1 ¬ u '(ct ) ¼
• So we can rewrite equation (1) as:

ª u '(ct 1 ) º § u '(ct 1 ) ·
1 E Et « » t
E (1  r jt 1 )  E cov t¨ , r jt 1 ¸
¬ u '( c )
t ¼ © u '( ct ) ¹
1  Et (r jt 1 ) § u '(ct 1 ) ·
 E covt ¨ , r jt 1 ¸ (1'')
1  r ft 1 © u '(ct ) ¹
 Lucas model VIII

Consumption betas

• We can obtain a relation between excess returns and the

covariance of the return with the stochastic discount
factor:
§ u '(ct 1 ) ·
Et (r jt 1 )  r ft 1  E (1  r ft 1 ) covt ¨ , r jt 1 ¸ .
© u '(ct ) ¹
™ A security has a positive (negative) risk premium if its return is
positively (negatively) correlated with aggregate consumption.

™ Expected excess returns can be predictable if the conditional

variance of returns, its conditional correlation with
consumption growth or risk aversion change predictably.

Lucas model IX

Consumption betas

• We can recover the familiar CAPM-relation of excess

returns by assuming quadratic utility, which implies:

u '(ct ) a  bct

• In this case, the expression for excess returns becomes:

E (1  r ft 1 )
Et (r jt 1 )  r ft 1 
a  bct

covt a  bct 1, r jt 1 .
E b(1  r ft 1 )
a  bct

covt ct 1, r jt 1 .
 Lucas model X

Consumption betas

• Divide the expression above for any asset j by the same

expression for an asset Z whose return is perfectly
correlated with aggregate consumption:

Et (r jt 1)  r ft 1 
covt ct 1, r jt 1  
covt ct 1, r jt 1  E jt .
Et (rZt 1)  r ft 1 covt  ct 1, rZt 1  vart  ct 1 

Note: these are equal by assumption!

• So we get:

Et (r jt 1)  r ft 1 E jt ª¬ Et (rZt 1)  r ft 1 º¼ .

Lucas model XI

CCAPM analogue of the SML

• But note that in this model the market portfolio (the N

“trees”) yields a dividend flow that IS equal to
consumption: so indeed the market portfolio IS asset Z !

• So, we get the CCAPM analogue to the security market

line (SML) in the CAPM:

Et (r jt 1)  r ft 1 E jt ª¬ Et (rMt 1)  r ft 1 º¼ .

… except for one difference: these are conditional expectations and betas!
 Testing the C-CAPM
I

Testing the C-CAPM

• Empirically testing the C-CAPM turns out to be as

difficult as testing the standard CAPM.

• First, there is no definitive model for the process of

asset payoffs F(˜).

• Second, the dynamic nature of the model implies a

conditional specification of the asset pricing equation:

§f · §f ·
p jt Et ¨ ¦ mt  s d jt  s ¸ E ¨ ¦ mt  s d jt  s It ¸ .
©s 1 ¹ ©s 1 ¹

Testing the C-CAPM

II

Testing the C-CAPM

• There is a problem with conditional models: the

information set It available to investors is not observable
by the econometrician.

• Also, a conditional specification implies that estimates

of asset betas, risk premia and expected returns are in
general time-varying.

• In contrast, static models such as the CAPM and APT

yield time-invariant betas and expected returns.
 Testing the C-CAPM
III

Scaled payoffs

• To escape the problem of conditioning information one

can use instrumental variables and “scaled payoffs”.

• Start from the conditional model pt Et (mt 1xt 1 ).

• Multiply both payoff and price by any variable or

instrument z t observed at time t:
pt zt Et (mt 1xt 1zt )
• Take unconditional expectations:

E ( pt zt ) E (mt 1xt 1zt ).

Testing the C-CAPM

III

Scaled payoffs

• The scaled payoff xt 1zt can be regarded as the payoff of

a managed portfolio ("invest according to the value of zt"),
with price pt zt .

• Note that the scaled payoff unconditional relationship:

E[(mt 1xt 1  pt ) zt ] 0
holds for every zt  I t (where I t { information at t ).
So it implies the conditional equation:
pt E (mt 1xt 1 It ).

• Problem: a lot of possible instruments! Practical limit.

 Testing the C-CAPM
III

Scaled factors

• Suppose that we model the discount factor mt+1 by a

linear factor model, with factors ft+1 and time-varying
parameters that depend on conditioning information:
mt 1 at  bt ft 1

• Then, we can write the time-varying parameters as a

linear function of the instrumental variable zt:

mt 1 a( zt )  b( z ) ft 1 a0  a1zt  (b0  b1zt ) ft 1

a0  a1zt  b0 ft 1  b1 ( zt ft 1 ).

Testing the C-CAPM

III

Scaled factors

• Then use this scaled-factor model to go from the

conditional price equation to the unconditional one:

pt Et ª¬ a0  a1zt  b0 ft 1  b1 ( zt ft 1 )  xt 1 º¼

Ÿ E ( pt ) E ª¬ a0  a1zt  b0 ft 1  b1 ( zt ft 1 )  xt 1 º¼ .

• Of course, one needs to identify variables z that are

capable of summarizing well the variation in conditional
moments. E.g., the dividend/price ratio and the term
structure premium, as in Jagannathan and Wang (1996).
 Testing the C-CAPM
IV

Scaled factors

• The variable zt ft 1 is referred to as a “scaled factor”

because it is the product of the instrumental variables
and the risk factors.

• This procedure again leads to an unconditional model

with constant parameters.

• Only the number of explanatory variables in the asset

pricing equation has increased substantially.

Session 14

Session 15

Consumption-based Asset Pricing II

 Session
Outline

Session Outline

• The equity premium puzzle

• Stochastic discount factors

• Hansen-Jagannathan bounds

• Resolutions of the puzzle

Equity premium
puzzle I

Mehra and Prescott

• Mehra and Prescott (1985) studied the congruence of the

C-CAPM with historical data on asset returns in the US

• They found three surprising stylized facts:

– the realized real excess return on a broad index of

stocks is about 6% per year

– the standard deviation of these index returns is only

about 19%

– the realized real rate of return on short-term

government bonds is only about 1% per year
 Equity premium
puzzle II

Mehra and Prescott

• These empirical facts are robust over time and across

countries

• They essentially falsify the standard C-CAPM with

time-separable CRRA-utility

• An infinitely-lived, representative agent with CRRA-

utility cannot be induced to hold large quantities of the
riskless asset given these returns

• The agent would be short in the riskless asset and hold a

very risky portfolio

Equity premium
puzzle III

Mehra and Prescott

• The subsequent literature has identified a “riskless rate”

puzzle from these data because the return on bonds is
unexpectedly low

• These results are damaging not only for the C-CAPM

but also for most other macroeconomic models based on
a representative agent with CRRA-utility

• The literature has been extended in various directions

and risk premium puzzles were also detected in
education, private businesses and other areas
 Stochastic discount
factors I

Stochastic discount factors

• This result was produced via simulations, but can be

approximated also by algebraic calculations

• We start from the pricing equation for returns

which yields a relation between excess returns and

second moments

Stochastic discount
factors II

Stochastic discount factors

• Correlation coefficients lie in the interval [-1,1] and

hence

• The Sharpe ratio of an asset is defined as

• Choosing a discount factor derived from power utility

ª ctJ1 º
E  mt 1  E E « J »
¬ ct ¼
 Stochastic discount
factors III

Stochastic discount factors

• We get

which holds as an equality for efficient frontier

portfolios (they obtain the maximum Sharpe ratio)

• The right hand-side can be approximated by a much

simpler expression

Stochastic discount
factors IV

Stochastic discount factors

• This approximation is exact if consumption growth is

lognormally distributed and time is continuous

• We first write

and then exponentiate and take logs

 Stochastic discount
factors V

Stochastic discount factors

then lognormally distributed consumption growth

implies that

Stochastic discount
factors VI

Stochastic discount factors

which after cancelling terms yields

• In continuous time, we could use the property of

continuously compounded returns to get the following
approximation
 Risk aversion

Implied risk aversion

• This approximation gives a relation between the Sharpe

ratio (slope of the efficient frontier), the risk aversion
parameter J and the volatility of consumption growth

• Empirically, the Sharpe ratio of annual market returns is

relatively large and is estimated to be around 0.3 to 0.5

• The standard deviation of annual aggregate

consumption growth is about 0.01

• This leaves an estimate of J of 30-50, an unusual degree

of risk aversion generally estimated between 2 and 5

Risk-free rate

Implied risk-free rate

• Assuming these high levels of risk aversion would

require a much higher riskless rate as can be seen from
approximating

• Here 1% consumption growth and J between 30 and 50

requires either a riskless rate of at least 30-50% or a
negative discount factor G
 Discount factor
volatility I

Volatility bounds

• Another implication of historical asset return data

restricts the volatility structure of the discount factor

• The Sharpe ratio of the market return is related to the

discount factor via

• With a riskless rate of 1% this puts a lower bound on the

standard deviation of the discount factor of about 50%

Discount factor
volatility II

Volatility bounds

• The conditional mean of the discount factor is the

inverse of the riskless rate which is relatively stable

• Empirically, the standard deviation of the real riskless

rate is about 5%

• Now decompose the variance of the discount factor as

the variance of the conditional mean and the variance of
the unexpected component
 Discount factor
volatility III

Volatility bounds

• The unexpected component of the discount factor must

vary a lot more than the conditional mean to obtain the
required variation of the discount factor at low levels of
risk aversion

• The estimated standard deviation of the unexpected

component would be

Resolutions I

Resolutions of the puzzle

• Only consumption-based asset pricing models can

capture the equity premium puzzle because they derive
the discount factor from fundamentals

• The resolutions to the puzzle generally take one of two

possible approaches

¾ Modify utility to produce a suitable discount factor

process

¾ Introduce heterogeneity or frictions that modify the

structure of the consumption-based model
 Resolutions II

Resolutions of the puzzle

• Epstein and Zin (1989) provided a first resolution of the

puzzle by introducing a recursive utility representation

• The key property of this class of preference is that they

separate risk aversion from the incentive to substitute
consumption intertemporally

Resolutions III

Resolutions of the puzzle

&RHIILFLHQWRI
UHODWLYHULVN
DYHUVLRQJ

Log-utility
1

CRRA-utility
(ODVWLFLW\RI
LQWHUWHPSRUDO
1 VXEVWLWXWLRQ\

• The elasticity of intertemporal substitution is given by

 Resolutions IV

Resolutions of the puzzle

• For 1 - J = U this class of preferences reduces to

standard time-separable CRRA-utility

• The additional flexibility allows the discount factor to

simultaneously match the low variability of
consumption with a large risk premium for taking asset
return risk

• The main disadvantage of this form of utility is that it is

not consistent with expected utility maximization if
return realizations affect future decisions

Resolutions V

Resolutions of the puzzle

• Campbell and Cochrane (1999) retain time-separability

but introduce habit formation into CRRA-utility

• The consumption habit xt affects the curvature of the

utility function and hence risk aversion

• It slowly adapts to the current level of consumption

 Resolutions VI

Resolutions of the puzzle

• The discount factor implied by this model is simply

• Assuming that income growth is iid and lognormal, one

can derive the equilibrium path of consumption and
consumption habits

• The real interest rate is given by

Resolutions VII

Resolutions of the puzzle

• The model resolves the equity premium puzzle by

producing time-varying risk aversion

• If consumption is low relative to the habit, risk aversion

and required equity returns are high

• The real interest rate remains low, because of the strong

precautionary savings motive implied by the habit

• Time-variation in risk-aversion and the Sharpe-ratio

also implies return predictability
 Resolutions VII

Resolutions of the puzzle

• Duffie and Constantinides (1996) argue that stochastic

labor income produces an equity premium even with
low risk aversion

• In their model agents are heterogeneous due to different

labor income shock realizations

• Because labor income shocks are permanent and

uncorrelated with market returns agents cannot smooth
consumption by trading with each other

Resolutions VIII

Resolutions of the puzzle

• The key assumption is that labor income shocks are

more variable when the market return is low

• Agents are facing a higher risk of low consumption due

to low labor income realizations precisely when market
returns are low - this produces an equity premium

• The real interest rate is not affected by this correlation

and can therefore be kept low by choosing a low J
 Resolutions IX

Resolutions of the puzzle

• A whole set of papers argues that limited participation

in the stock market explains the equity premium puzzle

• The key idea of these papers is that aggregate

consumption does not produce the correct discount
factors because few households actually hold stocks

• Ait-Sahalia and Parker (2003) show that if one takes

consumption of luxury goods as the basis for discount
factors, the equity premium puzzle disappears

Resolutions X

Resolutions of the puzzle

• Luxury goods consumption is much more variable than

aggregate consumption and is more highly correlated
with stock market returns

• Mehra, Constantinides and Donaldson (2002) argue that

middle-aged households finance a large part of their
consumption through asset income

• For these households, consumption is highly correlated

with asset returns and they therefore require a larger risk
premium
 Resolutions XI

Resolutions of the puzzle

• The low riskless rate in these models is consistent with a

low risk aversion coefficient and broad participation in
the savings market

• Limited participation can be caused by transaction costs

in the equity market and borrowing constraints

• So far, none of the models has been universally

accepted as the “best” way to explain the equity
premium puzzle

Session 16

Market Efficiency
 Session outline

• Efficient markets hypothesis

• Serial correlation of returns

• Rational bubbles

• Time-varying risk premia

Motivation

• There is a long debate in economics about whether

financial markets are informationally efficient, that is,
use all the available information to set prices.

• According to Samuelson (1958): “Financial markets are

micro-efficient, but macro-inefficient”.

• Fama (1971) argued instead that unforecastability of

stock returns is the most convincing proof of stock
market efficiency. If not, some investors could make
unlimited speculative profits at the expense of others.
 Efficient market hypothesis

• Fama (1970) defines market efficiency as:

¾ Market prices are capturing all information available

to the investors up to the current period.

• He also distinguishes 3 variants of the efficient market

hypothesis that differ with respect to the information set:
- Weak form: past returns.
- Semi-strong form: all publicly available information.
- Strong form: all public and private information.

Formal statement

• The efficient market hypothesis is only defined with

respect to an information set which determines
expectations about future payoffs.

• The simple martingale hypothesis states that asset prices

follow a martingale process with the property:

• If prices follow a martingale, returns are unforecastable:

 Random walk

• The “random walk hypothesis” is a special case of the

martingale hypothesis:

• It has been shown that efficient markets indeed imply

the martingale property of prices, but only after an
appropriate adjustment for systematic risk.

• This implies that market efficiency can only be tested

empirically after specifying a model of expected returns.

Efficient markets: risk neutrality vs. risk aversion

• Under risk neutrality, the efficient market hypothesis

would imply that the error Ht+1 has zero conditional
expectation and is serially uncorrelated in the equation:

• Under the CAPM, we would expect this to be the case

in the regression:

• But note: the risk premium may change predictably!

More on this later on…
 Serial correlation of returns

• Recent empirical work has shown that stock returns are

serially correlated.

• A simple test of serial correlation uses the estimated

autocorrelation function of stock returns.

• The Box-Pierce statistic

tests the joint significance of the first K autocorrelation

coefficients and has an asymptotic F2(K)-distribution.

Serial correlation of returns

• Most studies find small negative autocorrelation for

daily returns of individual stocks.

• Weekly index returns are found to be positively

correlated for a horizon of about 6-12 months.

• At longer horizons of more than 3 years and monthly

return frequencies, index returns are substantially
negatively correlated.

• Longer frequency returns are also negatively correlated.

 Long-term predictability

• Even more significantly, at return frequencies of more

than 1 year, index returns are predictable by the
dividend-price ratio .

• This finding has been produced by Fama and French

(1988) in a regression of K-period returns on the
dividend-price ratio at the beginning of the period:

• The R2 of this regression is largest for K = 3 years.

Long-term predictability

• Most financial economists interpret these findings as

evidence that expected returns are time-varying rather
than constant over time.

• Suppose that the risk premium rises at time t because

the conditional estimate of market volatility has risen:
• The current price pt will decline to generate an increase in
expected returns and compensate investors for the extra risk.

• On average, subsequent returns Rt,t+k will be higher Ÿ spurious

correlation due to an omitted variable (the risk premium)!
 Rational bubbles

• Assuming that the results are robust, one possible

interpretation that delivers time-varying expected returns
is that markets produce asset price bubbles.

• When the bubble component is small or lacking, dividends

are high relative to stock prices, and average returns in the
future (when the bubble will grow) are high.

• When the bubble component is large, dividends are low

relative to prices, and average returns in the future are low
as well (because some time the bubble will burst).

Rational bubbles

• To link up prices, dividends and returns, let us start with

the definition of a simple gross expected return and
assume it to be constant over time (equilibrium with risk
neutrality):

• This implies that price in period t is given by:

 Rational bubbles

• Recursively substituting for future prices we obtain:

• The second term captures the bubble component and

represents the discounted value of future expected price.

• The transversality condition rules out the bubble term in

the indefinite future:

Rational bubbles

• The transversality condition binds only at an infinite

horizon. Hence, a theoretical possibility of finitely lived
bubbles exists.

• However, in various settings rational bubbles can be

ruled out:

- if there is an infinitely lived agent,

- if there is an upper/lower limit on the asset’s price,

- if the asset has a fixed terminal value.

 Gordon growth
model I

Gordon growth model

• If bubbles are ruled out, price in period t equals its

fundamental value:

• This pricing formula simplifies if we assume a constant

dividend growth rate g < r:

Gordon growth model

• Substituting out future dividend payments, we get:

• This gives a simple expression for the dividend-price

ratio:

• If dividend growth is not constant but stationary, prices

and dividends must be cointegrated.
 Time-varying risk premia

• Another way to generate return predictability is to drop the

assumption that expected returns are constant over time.

• In this case, the present value model is non-linear

• To show how current price, future dividends and future

returns are related if the expected return is time-varying,
we take a log-linear approximation of this formula.

Time-varying risk premia

• Start from the definition of the realized log stock return

• We first-order approximate at
 Time-varying risk premia

• Substituting into the above expression we get

• A compact expression for the realized log return is:

Time-varying risk premia

• We can use this approximation to relate current prices to

future returns and dividends.

• Write:

• Substituting for future prices, we get

 Time-varying risk premia

• The relation above is a simple accounting identity and

should therefore also hold for expectations that are
consistent with accounting identities:

• This equation implies that the current price is a function

of expected future dividends and expected future
returns.

Time-varying risk premia

• Now we can show why the dividend-price ratio is a

predictor of expected future returns.

• The approximation of the log stock return also yields a

relationship between the log dividend-price ratio,
dividend growth and future returns:
 Time-varying risk premia

• Proceeding as before, we get

which relates the current dividend-price ratio to

expected dividend growth and expected returns.

• One can see that a low dividend-price ratio (prices are

high relative to dividends) has to be followed by either
high dividend growth or low expected returns.

Time-varying risk premia

• Empirically, dividend growth is roughly constant over

time and therefore most of the variation in the dividend-
price ratio data must come from expected returns.

• Within a rational pricing model, variation in expected

returns is caused by a risk premium compensating the
investor for taking some systematic risk.

• One interpretation of these findings is that at business

cycle frequencies risk premia vary due to changes in
consumption habits.
 Time-varying risk premia

• Another interpretation is that risk premia vary due to

changes in liquidity risk.

• In recessions, liquidity risk and future expected returns

are high, while in booms liquidity risk and future
expected returns are low.

• However, no fully specified model spelling out the

relation between liquidity risk and asset returns exists.

Session 17

Bond Pricing
 Session
Outline

Session Outline

• Definitions

• Yield measures

• Term structure of interest rates

• Expectations hypothesis

• Duration and convexity

Definitions I

What is a bond?

• A bond (or fixed-yield security) is a financial instrument

with a rigid cash-flow structure:

- Investors buy a bond of value K at some price p0.

- They receive coupon payments ct at predefined
points in time t = 1,…, T.
- At time of maturity T, the value of the bond K is
repaid.

• The main tool necessary to price such an asset correctly

is a series of discount factors.
 Definitions II

Types of bonds

• There are three main categories of bonds traded in

financial markets:

- Public debt: often serves as a benchmark for

inflation risk.

- Corporate bonds: because of bankruptcy these

instruments carry “default risk”.

- Commercial paper: a short-term form of financing

widely used in the US.

Definitions III

Yield measures

• There are various ways to measure the yield (interest

rate) of a bond.

• We will discuss four different measures:

- Yield to maturity.

- Coupon yield.

- Spot interest rate.

- Forward interest rate.

 Definitions IV

Yield to maturity

• This is the internal rate of return (IRR) of holding the

bond from the current period t until maturity T.

• It is computed as the variable yt that solves the equation:

• Obviously, for a given price P0 and total cash flow

, the internal rate of return is

higher the earlier the payoff occurs.

Definitions V

Yield to maturity

• Yields to maturity are derived from a non-linear

relationship and are therefore not additive.

• To compute the yield to maturity of a portfolio of

bonds, one must resolve the yield-to-maturity equation
for the new cash flow structure implied by the portfolio.

• The non-linearity manifests itself also in the fact that for

a given cash flow structure {cs}s=tT the relationship
between price pt and yield to maturity yt is convex.
 Definitions VI

Coupon yield

• The coupon yield yct is simply calculated as the ratio of

the payout (coupon payment) to the price in period t :

• While this provides a short-run measure of the return

generated by the bond, it does not take into account
future payment streams and price changes.

• Nevertheless it is a widely used measure.

Definitions VII

Spot interest rate

• The spot interest rate ysT-t for horizon T t is given by

the yield to maturity at time t of a zero-coupon bond
with maturity at time T.

• A zero coupon-bond does not provide coupon

payments, so that the formula for yield to maturity
reduces to:

• Spot interest rates are a pure measure of the discount

factor used by the market for the period T t.
 Definitions VIII

Term structure of interest rates

• If the spot interest rates are known for a sequence of

maturities, we obtain the “term structure of interest
rates”.

• This curve relates time until maturity to spot interest

rates and can be used as a basis for discounting certain
future payoffs to the present.

• If bond prices do not reflect the same “term structure of

interest rates”, arbitrage opportunities arise.

Definitions IX

Forward interest rate

• A forward interest rate relates two future periods.

• It is applied to contracts written at period t0 that commit

the contracting parties to cash flows in periods t1 and t2.

• The forward interest rates are implicit in the term

structure of interest rates.

• Assuming t = 0, the T-period spot rate implies a payoff

x after T periods of holding a zero-coupon bond of:
 Definitions X

Forward interest rate

• This has to equal the payoff of holding a zero-coupon

bond for T-n (n < T) periods and writing a contract
about investing its payoff for n periods at the forward
interest rate y fT-n,T

• Rearranging, we get

Definitions XI

Forward interest rate

• If the forward contracts do not reflect the current term

structure of interest rates, arbitrage opportunities arise.

• In fact, the term structure of spot interest rates implies

the term-structure of forward interest rates.

• Analogously to the term-structure of spot interest rates it

relates the forward interest rates at some future period t
to the maturity T-t.
 Term structure I

Estimating the term structure

• The term structure of interest rates is the fundamental

tool in order to price bonds correctly.

• To obtain the current term structure one would ideally

like to observe the prices of zero-coupon bonds without
solvency risk at various maturities.

• If these are not available for some maturities, one can

use observed forward interest rates to “fill the gaps”.

Term structure II

Estimating the term structure

• Unfortunately, due to lack of data on these instruments

the term structure very often has to be estimated from
observed prices of coupon-bonds.

• Using prices pn and cash-flows cnt of a single bond for

each maturity (N=T) one can recursively calculate a T-
period term structure for n = 1,2,…,N from
 Term structure III

Estimating the term structure

• The result of such a calculation depends heavily on the

particular bonds chosen.

• A more reliable alternative is to estimate the term

structure from a cross-section of J (J>T) prices pj and
cash-flows cjt:

Term structure IV

Estimating the term structure

• The coefficients

in this regression yield the spot interest rates.

• The X-variables capture the effects of non-term structure

related factors like taxation, callability, liquidity and
asynchronous trading that also affect bond prices.

• The term structure is usually positively-sloped, but at

certain times has been observed to be hump-shaped or
negatively sloped.
 Expectations
hypothesis I

Expectations hypothesis

• Once a term structure of interest rates has been

estimated, one can consistently price any certain cash-
flow sequence.

• To understand how the term structure of interest rates

might change in the future, we would like to have a
theory of what determines the term structure.

• The most widely held view is called “expectations

hypothesis”.

Expectations
hypothesis II

Expectations hypothesis

• This hypothesis assumes risk-neutrality or a constant risk

premium OW and in this way relates spot rates at different
points in time:

• The interpretation of this formula is that the long-term

current spot rate, ys0,t+W , is a function of the current and
expected future short-term spot rates, ys0,t and E0[yst,W].
 Expectations
hypothesis III

Local expectations hypothesis

• The hypothesis cannot hold for all maturities at the same

time, unless the expected spot rates are constant at all
maturities (i.e. the expected term structure is flat):

• It is widely accepted when stated in terms of the one-

period rate, but in that case is referred to as the local
expectations hypothesis:

Expectations
hypothesis IV

Local expectations hypothesis

• The local expectations hypothesis has two important

implications:

¾ The expected one-period spot rates plus risk

premium must equal the forward rate at all horizons:

¾ Expected one-period holding returns are equal for

bonds of all maturities:
 Duration I

Duration of a bond

• The realized return of a bond can be decomposed into

two components, the coupon yield and the realized
capital gain:

• The realized capital gain itself can be decomposed into

an expected and an unexpected component:

Duration II

Duration of a bond

• The expected capital gain in the price of a zero-coupon

bond is easy to calculate if the term structure is flat and
hence ysT = i for all T.

• The price is then simply given by

and the expected capital gain is
 Duration III

Duration of a bond

• We continue to assume that the term structure is flat, but

allow for an unexpected change in the interest rate 'i to
compute an approximation of the unexpected capital gain.

• Using logs:

Duration IV

Duration of a bond

• Increases in the interest rate therefore reduce the price of

a zero-coupon bond.

• The reduction in price is larger, the larger the maturity of

the bond.

• The elasticity of the price of a bond with respect to

changes in the interest rate is measured by the bond’s
“duration” D defined as:
 Duration V

Duration of a bond

• For a zero-coupon bond, duration is equal to maturity:

• Regular coupon bonds can be regarded as portfolios of

zero-coupon bonds.

• The duration of a coupon bond can therefore be calculated

as a weighted average of the maturities of its cash-flows.

Convexity I

Convexity of a bond

• Elasticity is a local measure and duration is therefore a

valid measure of the effect of interest variation on price
only for small changes in interest rates.

• If interest rate variations are large, we also want to take

into account the second order-effect, because the price of
a bond is a convex function of its yield.

• The adjustment to the duration formula that is needed is

therefore also called the “convexity” of a bond.
 Convexity of a bond

• Taking into account the second derivative, the

unexpected change in the price of a bond is:

• With a flat term structure, the convexity of a zero-

coupon bond is given by: