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Asset Pricing 2
Course requirements and organization
Asset Pricing 3
Course outline
Asset Pricing 4
Literature
The following textbook has the biggest overlap with the course (but also
contains a lot of material not covered in this course):
Cochrane: Asset Pricing, 2005, in particular: chapters 1 (not 1.5), 9 (only
9.1), 12 (only 12.3), 20, 21 (21.1), Revised Edition.
1st edition will do but check out the typo list on Cochrane‘s homepage.
The reading list contains papers that will be discussed in class or serve as
a basis for problems
Other sources which also cover parts of the course:
– Campbell/Lo/MacKinlay: The Econometrics of Financial Markets.
– Lengwiler: Microfoundations of Financial Economics.
– Constantinides: Rational asset pricing, Journal of Finance 57, 2002,
1567-1591.
– Campbell: Asset pricing at the millenium, Journal of Finance 55, 2000,
1515-1567.
Suggestions for further reading
– Shiller, R.: Irrational Exuberance.
– Garber, P.: Famous First Bubbles.
– Lewis, M.: The Big Short.
Asset Pricing 5
Reading list
Asset Pricing 6
What asset pricing is about
consistent?
understand
Asset Pricing 7
An example of the issues we address: Understand the average
return on stocks
Questions we ask
What return on stocks can we reasonably expect over the long run?
What is the expected return on stocks over the next three years?
Asset Pricing 8
Real value of a dollar invested at the end of 1925 (until 2017)
2182.8
1000
410.3
15.1
10
9.4
1.4
0,1
1926 1941 1956 1971 1986 2001 2016
Sources: http://www.hec.unil.ch/agoyal/
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Asset Pricing 9
Value of a dollar invested at the end of 1989
20
15
10
Source: Datastream
Asset Pricing 10
Course outline
Asset Pricing 11
Payoffs and returns and the notation that we will use
price: p
payoff: dollar amount that an investment returns x
gross return: payoff relative to the investment R=x/p
net return: gross return - 1 r
Example: I buy a stock today at 100 and sell it one year later at 110.
=> The payoff is 110
=> the gross return is 110/100 = 1.1
=> the net return is 110/100 – 1 = (110-100)/100 = 10%
We will often say just return which can then mean gross or net.
As notation differs across papers, we won‘t always stick to the notation from
this slide.
Asset Pricing 12
Timing conventions
t-1 t t+1
Asset Pricing 13
Timing conventions – special cases
We usually work with end-of-period prices. Talking about the stock price in
year t, we usually think about the stock price from the end of December of year
t. For a flow variable such as consumption, conventions are less clear cut.
We can think of consumption data as measuring consumption at the end of the
year. An annual growth rate for year t would then be ct/ct-1 - 1. But one can also
think of consumption data as measuring consumption at the start of the year.
The annual growth rate for year t would then be ct+1/ct - 1
The risk-free asset is not only special in terms of risk but also in terms of the
timing convention. Why? The one-period interest rate that the risk-free asset
offers at time t is the same as the return that it offers from t to t+1.
This is why there‘s two common conventions. Sometimes Rtf refers to the
return that can be earned from t-1 to t, similar to the convention for risky
assets. Sometimes Rtf refers to the rate at time t, and thus to the return that
can be earned from t to t+1. It’s mostly obvious which convention is used.
Asset Pricing 14
A note on notation
Ideally, these slides would be consistent with respect to notation but neither
Cochrane’s book nor the literature is.
My response was to be consistent with the main literature that a chapter builds on.
Asset Pricing 15
Compounding and log returns
lnR0,T = lnR·T
RT = exp(lnR·T)
Asset Pricing 16
Real rates of return
Asset Pricing 17
Happiness / utility
W. Jevons, 1871
F. Edgeworth, 1881
Asset Pricing 18
Modeling choice behavior: utility functions
Note: This example is simplified because we assume that we only derive utility from
Bounty or Mars. But in real life there is other consumption that matters which is why we
should consider u(other consumption, B, M)
Asset Pricing 19
Modeling choice behavior under uncertainty: expected utility
maximization
Again, u(c) describes how much utility you derive from consuming c
But now c is not certain. Say because it is next year’s consumption and we
don’t know how much we will earn next year
Under certain conditions, it is possible to show theoretically that one can
describe human behavior as if people maximize expected utility
E[u(c)] max
Note that maximizing E[a + b∙u(c)] with a and b constant and b>0 is
equivalent to maximizing E[u(c)].
Asset Pricing 20
The most widely used utility function in asset pricing is power
utility: (c1- - 1)/(1-), > 1
Asset Pricing 21
Concavity of u implies risk aversion
u[E(c)]
u(c)
E[u(c)]
c
c1 E(c)
Asset Pricing 22
Measuring risk aversion – relative risk aversion
u" (c )
RRA(c) = c
u'(c)
Interpretation: What is the relative change in u’(c) for a small relative change
of c?
du' (c ) / u' (c) u' ' (c)
RRA(c) = = c
dc / c u' (c)
Properties of RRA(c):
The higher RRA(c), the higher the risk aversion
Risk aversion is measured locally for a consumption of c
RRA(c) is appropriate for measuring preferences in situations of the type:
Either lose 10% of your wealth or gain 12% of your wealth.
Asset Pricing 23
An illustration of constant relative risk aversion with expected
utility function c1-/(1-)
Asset Pricing 24
Application: utility of an insurance
Asset Pricing 25
Course outline
Asset Pricing 26
Utility maximization and prices in a two-period economy
Asset Pricing 27
The stochastic discount factor
u ' (ct 1 )
pt u’(ct) = Et [ u’(ct+1) xt+1 ] => pt = Et xt 1
u ' (ct )
u ' (ct 1 )
We define mt+1= and call it stochastic discount factor
u ' (ct )
pt = Et[mt+1 xt+1]
Asset Pricing 28
The stochastic discount factor vs. discount factors in classical
finance analysis
xt 1 1 Et ( xt 1 )
pt = Et[mt+1 xt+1] pt = Et = Et xt 1 =
1 r 1 r 1 r
Asset Pricing 29
Deriving discount factors in the `classical´ way
xt 1
Et (1 rt 1 ) = Et
p
t
E t ( x t 1 ) x
pt = = E t t 1
1 r 1 r
The derivation shows that discount rates r are the same as expected returns.
Asset Pricing 30
Classical discount factors can still be useful, e.g. as a workhorse
for quick assessments or illustrations
Consider a stock as an asset that offers a stream of dividends plus the price
you fetch for it at the end of times, further assume that
Et p t i
lim
i i
= 0 then:
(1 r )
d t i
pt = Et i
i =1 (1 r )
Now assume that dividends grow at an expected rate g, meaning
Et [dt+i] = dt (1+g)i
We then get
d t i Et [d t i ] d t (1 g ) i d t (1 g ) [ ]
pt = Et i
= i
= i
= =
i =1 (1 r ) i =1 (1 r ) i =1 (1 r ) rg −
The formula is called Gordon growth formula and is great for quick back-of-
the-envelope calculations
Asset Pricing 31
Clarifying the difference between asset pricing and valuation
Asset Pricing 32
Understanding the risk-free rate of return Rf = xt+1/pt where xt+1 is
known with certainty
2
rt f = ln( ) Et ln ct 1 s t2 ( ln ct 1 )
2
Asset Pricing 33
The higher the covariance with consumption, the lower the price
E ( x) E ( x ) cov u ' ( ct 1 ), xt 1
p= f
cov(m, x ) = f
R R u ' ( ct )
E (R i ) R f = R f cov(m, R i )
Asset Pricing 34
Pricing with betas
i 2
i f cov( m , R ) s (m)
E ( R ) R = 2
= i ,m lm
s (m) E (m)
Asset Pricing 35
Mean-variance frontier
s (m )
i f
E (R ) R
E (m )
s Ri
Asset Pricing 36
Understanding the return on a risky asset
c
1 = Et t 1 Rt 1
ct
Asset Pricing 37
From two periods to infinite horizon and back
Investor maximizes Et j u (ct j )
j=0
pt = Et mt ,t j xt j
j =1
Since the equation holds in t+1 for xt+1+j we can reduce it to a two-period
version pt = Et[mt+1 (pt+1+ xt+1) ]
Asset Pricing 38
From two periods to infinite horizon and back (explained)
Investor maximizes Et j
u (ct j ) max u (et apt ) Et j u (et j axt j )
j =1
j =0
FOC: pt u ' (ct ) Et j u ' (ct j ) xt j = 0
j =1
In t we get:
j
u ' (ct j )
pt = Et xt j = Et mt ,t j xt j
j =1 u ' (ct ) j =1
Likewise in t+1: pt 1 = Et 1 mt 1,t j xt j
j =2
The two together give:* pt = Et mt ,t j xt j =Et mt ,t 1 xt 1
mt ,t j xt j
j =1 j =2
= Et [mt ,t 1 xt 1 mt ,t 1 pt 1] = Et [mt ,t 1(pt 1 xt 1 )]
Asset Pricing 40
Closed-end funds and net asset value
Asset Pricing 41
Stochastic discount factor and absence of arbitrage
Asset Pricing 42
Market efficiency
Asset Pricing 43
Course road map: Where do we go from p = E(mx)?
Chapter
What matters for the price of an individual asset is covariance with the
discount factor. We examine the CAPM, a model that makes this
E ( xi ) relationship more tractable by making additional assumptions. 3
pi = f
cov(m, xi )
R Empirical questions: Do stocks with higher covariance have higher
returns?
Asset Pricing 44
Course outline
Asset Pricing 45
Deriving the CAPM in a two-period world with multivariate
normally distributed returns and exponential utility U(c) = -e-c
The expected return on an asset is the risk-free rate plus beta times the
expected excess return on the market portfolio, the portfolio containing all
risky assets
E ( R i ) = R f i , R m [ E ( R m R f )]
Equivalent formulation
mt 1 = a bRtm1
Asset Pricing 47
Some remarks on the CAPM (1)
Who developed the CAPM? Sharpe (1964), Lintner (1965) and Black (1972)
What is the market portfolio? – The portfolio containing all risky assets,
weighted by their market values
Asset Pricing 48
Some remarks on the CAPM (2)
Asset Pricing 49
Some problems when testing the CAPM
Asset Pricing 50
Testing the CAPM: Fama/MacBeth procedure for estimating the
CAPM
rite = it lt it , i = 1, 2,..., N
T T
1 ˆ , ˆ = 1
Estimate l and : lˆ = l t i ˆ it
T t =1 T t =1
Then test
- significance of l̂ with a t-test: t = lˆ / s ( lˆ ) => “Does the factor matter for
pricing?”
- or that i are jointly zero (e.g. with the GRS test of Gibbons, Ross, and
Shanken (1989)) => Does the model fully explain average return
differences? Asset Pricing 51
Some more details on Fama/MacBeth
rite = it lt it , i = 1,2,..., N
Asset Pricing 52
Another procedure for testing implications of the CAPM
Or:
Sort stocks into portfolios based on a characteristic and analyze as
before. Then also check whether returns within these portfolios vary
with beta. This helps to assess whether it is the characteristic or the
beta that drives returns
If you haven‘t already done so, it‘s now a
good time to read Fama/French (1992): The
cross-section of expected stock returns,
Journal of Finance 47, 427-465.
Asset Pricing 53
Some results from Fama/French (1992) based on US data from
1963-1990
2,5 2,5
2 2
1,5 1,5
1 1
0,5 0,5
0 0
0,0 0,5 1,0 1,5 2,0 2,5 3,0 0,75 1 1,25 1,5
BE/ME Beta
Asset Pricing 54
Some results from Fama/French (1992) based on US data from
1963-1990
1,6
avg. monthly return (%)
1,4
1,2
1
0,8
0,6
0,4
0,2
0
0 0,5 1 1,5 2
Beta
Asset Pricing 55
From the CAPM to multifactor models
CAPM is a one-factor model but empirical evidence suggests that one factor
is not enough
Theoretical foundations for multifactor models:
ICAPM (Intertemporal CAPM)
- multi-period analysis
- allow changes in investment opportunities
=> more than one factor needed (intuition: pay higher price for assets that do
well if investment opportunities deteriorate)
K
APT (Arbitrage Pricing Theory) e
ri = ij f j i
- start with statistical analysis j =1
- if var(i) -> 0 apply law of one price => price assets with factors
Extending the CAPM (1): Fama-French three-factor model
As a fund manager
– you’d like to have a positive and significant alpha
– Having just high average returns is not enough because you may
have generated them by having a high beta or a tilt to small and
high book-to-market stocks
Asset Pricing 58
An alternative to return analysis with a factor model:
characteristics-matched benchmarks
Asset Pricing 60
Momentum and reversal: strategies based on past performance
Buying short to mid-term (1-12 months) winners and selling short to mid-
term losers is profitable (momentum)
– cannot be explained with Fama-French three-factors
Asset Pricing 61
Momentum is different
Consider a stock that has experienced low returns in the past. Price today
is therefore relatively low and:
– BM is relatively high (would imply high expected returns)
– Size is relatively small (would imply high expected returns)
– Stock is likely to belong to long-term losers (would imply high expected
returns)
– Stock is likely to belong to short-term losers (would imply low expected
returns)
Note the difference. If price is low because of some risk, BM, SIZE and
reversal are likely to predict the risk premium in some way. Momentum will
not pick it up as it makes the opposite prediction.
Asset Pricing 62
Extending the CAPM (2): Carhart four-factor model and Fama-
French five-factor model
where WML is the return on a winner minus loser portfolio, with winners
(losers) being stocks that performed best (worst) in previous periods.
Based on empirical findings as well as implied ceteris paribus relationships
between expected returns and current characteristics, Fama and French
(2015) suggest a five-factor model
Asset Pricing 63
Value/growth and momentum continues to be high on the
research agenda: Examples of recent papers
Asset Pricing 65
The equity premium puzzle: the basic equation is one we have
already looked at
0 = ln[ ] Et [ln Rt 1 ] E [ ln ct 1 ]
2
1 2
s [ln Rt 1 ] 2s 2 [ ln ct 1 ] 2s [ ln ct 1,ln Rt 1 ]
For the excess return of a risky asset over the risk-free we obtain:
s 2 [ln Rt 1 ]
E ln Rt 1 ln Rt
f
= s [ ln ct 1 , ln Rt 1 ]
2
Asset Pricing 66
The equity premium puzzle: what history (US 1889-2016)* implies
* Data from 1889 to 2009 are from Robert Shiller (chapt26.xlsx), from 2009 on from Datastream
** The formula was derived in a one-period model, where there is just one value for the risk-free rate.
In the data, there are multiple periods and the risk-free rate varies. It is not immediately obvious how
to best deal with this discrepancy. The common choice is to determine variances and covariances
with excess returns rather than with returns. Asset Pricing 67
Possible solutions 1: perhaps risk aversion is really that high –
but then we have a problem with the risk-free rate
Asset Pricing 68
Possible solutions 2: perhaps the equity premium is really not
that high
The standard error for the mean equity excess return in the data from
above is 1.6% (=> the true expected equity premium could be lower)
Survivorship bias:
– yes, we cannot easily conduct long-term studies for countries which
suffered economic disasters - or we do not regard them as important if
they did perform poorly
– but disasters often mean that the real risk-free rate is low
=> Reducing the expected equity premium mitigates the problem but it’s still
hard to reconcile the data with our model
Asset Pricing 69
Possible solutions 3: modify the utility function by introducing
habits
(Ct X t )1 1
t
E
t =0 1
Risk aversion thus depends on how far consumption is above habit,
St = (Ct - Xt) / Ct
Ct ucc (Ct X t ) C t
RRA = = =
uc (Ct X t ) Ct X t St
Asset Pricing 70
Possible solutions 4: use data that better capture the actual
consumption behavior
Asset Pricing 71
Other possible solutions
Asset Pricing 72
Stock market predictability: The textbook evidence (here 1926-
2016 data from Goyal/Welch, t-statistics based on Newey/West)
Asset Pricing 73
Dividend-price ratio over time (Goyal/Welch data)
12%
10%
8%
Dt / Pt
6%
4%
2%
0%
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016
Asset Pricing 74
Stock market predictability: 5-year annualized excess returns and
5-year forecasts using dividend-price ratio (Goyal/Welch data)
Actual Forecast
20%
log excess returns p.a.
10%
0%
-10%
-20%
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016
Asset Pricing 75
Why regression coefficients increase with horizon
rt 1 = bxt t 1,
x t 1 = x t t 1
rt 1 rt 2 = b (1 )xt b t 1 t 1 t 2
Asset Pricing 76
Predictability and rationality – some introductory thoughts
Asset Pricing 77
Some statistical doubts 1: Persistence means that a history of 80
years or so is actually quite short
Asset Pricing 78
Some statistical doubts 2: How to calculate standard errors of the
least squares coefficient b
With overlapping returns, we can no longer assume that error terms are
independent. Consider the data structure for five-year return regressions:
A commonly used estimator for standard errors in such a case is the one
by Newey/West. Ang/Bekaert (2006, Review of Financial Studies) show
that Newey/West may perform badly in predictability regressions because
of the persistence of the predictors. t-statistics are then typically
overestimated.
Alternative estimators (Hodrick 1992, Review of Financial Studies, or
bootstrap estimators) often turn significant statistics into insignificant ones.
Asset Pricing 79
Some statistical doubts 3: in-sample predictability does not
guarantee superior out-of-sample predictability
1 1 Pt 1 Dt 1
Start with identity: 1 = R Rt 1 = R
t 1 t 1
Pt
Pt P D
= Rt11 1 t 1 t 1
Dt Dt 1 Dt
Take logs: p t d t = rt 1 d t 1 ln( 1 e p t 1 d t 1 )
Asset Pricing 81
Understanding the drivers of dividend-price ratios (continued)
pt d t = rt 1 d t 1 ln(1 P / D ) ( p d ) ( pt 1 d t 1 )
Which implies
j 1
j 1
var( pt d t ) = cov pt d t , d t j cov pt d t , rt j
j =1 j =1
Asset Pricing 82
Understanding the drivers of dividend-price ratios (continued)
We obtained:
j 1
j 1
var( pt d t ) = cov pt d t , d t j cov pt d t , rt j
j =1 j =1
Which implies that if the dividend-price ratio varies (which it does in the
data) it must be because
– it forecasts changes in returns and/or
– it forecasts changes in future dividends
Asset Pricing 83
Empirical evidence on the drivers of dividend-price ratios:
Variance decomposition (Cochrane, 1992)
Dividends Returns
Real -34 138
Std. error 10 32
Nominal 30 85
Std.error 41 19
The table shows the fraction of the variance (in %) that is attributed to dividend
and return forecasts, respectively. The infinite sum in the formula
j 1
j 1
var( pt d t ) = cov pt d t , d t j cov pt d t , rt j
j =1 j =1
is approximated with a sum over the subsequent 15 years. Asset Pricing 84
Excess volatility: a mirror image of predictability
Var[P*] Var[P]
Empirical test: use actual dividends, assumption on final P* in data set and
assumption on discount rate to calculate ex post rational price for P*
Asset Pricing 85
Excess volatility: empirical evidence from Robert J. Shiller,
Speculative Asset Prices, Prize Lecture, 2013.
Asset Pricing 86
Explanations to previous slide
“To produce this figure, the present value of dividends for each date in 1871–
2013 was computed from the actual subsequent real dividends using a
constant real discount rate r = 7.6% per annum, equal to the historical average
real return on the market since 1871. […] I made some simple assumptions
about the as-yet-unseen future dividends, beyond 2013. This time I used a
conventional dividend discount model, the Gordon Model, using the most
recent 2013 S&P 500 real dividend as a base for forecasts of dividends after
2013 showing two alternative assumptions about dividends after 2013. In one, I
assumed that real dividends will grow forever from the last observed dividend,
in 2013, at the same average growth rate as over the most recent ten years,
5.1% per year, which gives a 2013 value of 1292 for P*. In another, the
calculations are the same but the growth rate of dividends after 2013 are taken
as the geometric average growth rate over the last thirty years, 2.5% a year.”
(Robert J. Shiller, Speculative Asset Prices, Prize Lecture, 2013, p. 468)
Asset Pricing 87
Why excess volatility is a mirror image of predictability
Asset Pricing 88
Excess volatility: discount rates that would equate P and P* (for
data from Shiller)
14%
Discount rate used in t
12%
10%
8%
6%
4%
2%
0%
Asset Pricing 89
Univariate predictability: mean reversion in stock prices
rt , t k = a b k rt k , t t k
var( rt ,t k )
k =
k var( rt 1 )
Asset Pricing 90
Univariate stock market predictability: (1926-2016 data from
Goyal/Welch)
Asset Pricing 91
Predictability continues to be high on the research agenda:
Examples of recent papers
Rapach, David E., Jack K. Strauss, and Guofu Zhou. "Out-of-sample equity
premium prediction: Combination forecasts and links to the real economy."
Review of Financial Studies 23.2 (2010): 821-862.
“Welch and Goyal (2008) find that numerous economic variables with in-sample predictive
ability for the equity premium fail to deliver consistent out-of-sample forecasting gains
relative to the historical average. Arguing that model uncertainty and instability seriously
impair the forecasting ability of individual predictive regression models, we recommend
combining individual forecasts. Combining delivers statistically and economically significant
out-of-sample gains relative to the historical average consistently over time”
Guettler, A., P. Hable, and P. Launhardt. "The Out-of-Sample Predictive Power of
Aggregate Insider Trading." Working Paper (2016).
“In this paper, we investigate whether aggregate insider trading improves the performance
of models forecasting equity premia commonly considered in the literature. We show that
aggregate insider trading contributes to most of these benchmark models in statistical and
economic terms. Furthermore, our investigation reveals that in contrast to previous studies
which confine predictability to recession periods, aggregate insider trading provides
investors with an indicator to improve forecasts in expansion. Lastly, based on insiders’ and
short sellers’ ability to predict cash flows, our results suggest that combining insider and
short selling information yields a valuable model to forecast equity premia.”
Asset Pricing 92
Course outline
Asset Pricing 93
Rationality and Behavioral Finance – questions we examine
Asset Pricing 94
USD/BITCOIN
Dow Jones
50
100
150
200
250
300
350
400
2000
4000
6000
8000
0
10000
12000
14000
16000
18000
20000
Dec-18
Oct-16
Dec-20
Dec-22
Apr-17
Dec-24
Some bubbles?
Dec-26
Oct-17
Dec-28
Dec-30
Apr-18 Dec-32
Dec-34
50
0
100
150
200
250
300
350
400
450
Mrz 89
Dec-10
Mrz 91
Dec-11
Mrz 93
Dec-12
Mrz 95
Dec-13
Mrz 97
Dec-14
Mrz 99
Dec-15
Mrz 01
Dec-16
Mrz 03
Dec-17
Mrz 05
Asset Pricing 95
Bubbles: some examples
“Three dot.com IPO examples can be used to illustrate what was happening to
valuations at the time: (1) At Home listed on Nasdaq on July 11th 1997. This broadband
Internet business had just 5,000 subscribers when it announced it was going public and
warned that “there can also be no assurance that the Company will ever achieve
profitability”. Nonetheless, At Home’s opening market capitalization was no less than
$2bn, reflecting a price to sales ratio of 1350 times; in due course its market
capitalization reached $22bn. (2) eToys was floated on Nasdaq on May 20th 1999. By
the end of the first day of trading its price was up 280%, valuing the company at 220
times its revenues, or $7.8bn, substantially exceeding the market capitalization of
Toys’R’Us with sales almost 400 times larger. At its peak, eToys was valued at well over
$10bn, despite losing $4 on every order, even ignoring marketing costs. (3) Webvan was
an on-line grocery home delivery business which filed for an IPO in early August 1999,
just two months after it started selling groceries. Its prospectus forecast losses of over
half a billion dollars between 1999 and 2001! Nonetheless, when Webvan finally listed
on November 5th 1999 its stock rose by two thirds on the offer price, valuing the firm at
$8bn, 20,000 times its annualized revenues. The claims and the valuations proved
hopelessly unrealistic. At Home filed for bankruptcy at the end of September 2001,
eToys declared its shares worthless in February 2001 and Webvan filed for Chapter 11
in July 2001.”
(from Tuffler/Tuckett (2005) A psychoanalytic interpretation of dot.com stock valuations,
Working Paper) Asset Pricing 96
Bubbles
Asset Pricing 97
Rational bubbles
In chapter 2 we derived pt = Et m
j =1
t ,t j x t j
For an equity investment that you hold until t= this can be written as
pt = Et m
j =1
t , t j dt j lim Et (m t ,t j pt j )
j
1 r
Bt t 1 , with probability p
Bt 1 = p
t 1 with probability 1 p
where E(t+1)=0
Asset Pricing 99
Another example for a rational bubble
Bt R 1
R Bt , with probability
Bt R 1
Bt 1 =
Bt R( 1)
1 with probability
Bt R 1
Many people argue that there must be a bubble if valuation levels imply
unrealistic growth rates (or returns)
But: if the dividend growth rate is uncertain we have - assuming that the
discount rate r is constant and ignoring uncertainty about d1 in = :
p0 1 1
= E >
d1 r g r E(g )
Example, if p0/d1 = 200 and r = 0.15, the implied known and constant g is
0.145, which may seem too high. But assuming that g is either 0 or x, each
with probability 0.5, the implied x is 0.1475. So an expected growth rate of
0.5*(0+0.1475) = 0.074 is sufficient to explain the high valuation level if the
uncertainty about earnings growth is large
* Pastor/Veronesi (2005) Was there a NASDAQ Bubble in the Late 1990s?, Journal of Financial Economics 81, 61-100.
A new technology arrives, but there is high uncertainty about the average
productivity of this new technology
Investors learn about this productivity before deciding whether to adopt the
technology on a large scale
For technologies that are ultimately adopted, the nature of uncertainty
changes from idiosyncratic (will this particular technology succeed?) to
systematic (once adopted across the economy, cash flows depend on
overall economic conditions)
=> There are two opposing valuation effects:
(a)Prices of technology stocks increase as investors learn that the
technology is likely to be successful
(b)Prices of technology stocks decrease as their systematic risk increases
because of adoption
We have a bubble-like pattern if effect (a) dominates first, effect (b)
afterwards
* Pastor/Veronesi (2009): Technological revolutions and stock prices, American Economic Review 99, 1451-83.
“I can calculate the motions of the heavenly bodies, but not the madness of
people” (Isaac Newton, upon losing money in the stock market during the
so-called South Sea Bubble)
„We document a striking positive stock price reaction to the announcement
of corporate name changes to Internet-related dotcom names. (...) For
example, the Wall Street Journal reports that Computer Literacy, Inc.,
changed its name recently to fatbrain.com because customers kept
forgetting or misspelling its Internet address computerliteracy.com. The
shares of the company jumped by 33 percent to $20.75 the day before the
company sent out an advisory about a name change, when leaks about the
name hit Web chat forums“ (Cooper, Dimitrov, Rau, 2005, A rose.com by
any other name. Journal of Finance 56, 2371-2388)
„But how do we know when irrational exuberance has unduly escalated
asset values, which then become subject to unexpected and prolonged
contractions as they have in Japan over the past decade?“ (Alan
Greenspan, former Fed Chairman, 1996)
„Do you really think Yahoo and [its] business model in 2015 will be anything
like it is now? The whole idea of your comparison is based on the flawed
assumption that Yahoo will be much like it is now. What people see is that
Yahoo is becoming the [I]nternet brand and whatever the [I]nternet becomes,
Yahoo will be at the center of it as long as they take the right steps.
Information/communication/media/entertainment will all flow through Yahoo if
they play their cards right. The sky is the limit.“
a_bird_on_the_wire (msg #180245, 12/31/1999)
„Amazon] is like tulips in Holland. It will wilt, just like they did. People will get
hurt, because there is too much margin buying going on here. This is 1929,
times ten… Watch out.“ INETMktg (msg # 191300, 12/09/1999)
„[T]here is more to investing than buying, [I]t is called selling. Heard the
saying, bulls make money, bears make money, pigs like [you] get
slaughtered.“ rohith2 (msg #19554, 12/26/99)
The postings are quoted from Fisher, K., and M. Statman. "Sentiment, Value, Asset Pricing 104
and Market-Timing." The Journal of Investing 13.3 (2004): 10-21.
Bubbles: some internet postings (continued)
„My 1000 shares haven’t don’t too damn well recently. My broker advised me
to sell in 2000, and I resisted. I’m an idiot. But I’m going to buy more.“
mobuto1 (msg #186651, 07/09/02)
„Shorts are the avatars of divine perfection. Gardens of flowers spring in their
footsteps. The soft glow of their halos brings comfort in the darkest night.
When they breathe, gentle perfumed zephyrs fill the air...“
nostradomissays (msg #187329, 07/10/02)
The postings are quoted from Fisher, K., and M. Statman. "Sentiment, Asset Pricing 105
Value, and Market-Timing." The Journal of Investing 13.3 (2004): 10-21.
Behavioral Finance is built around anomalies and psychology
Anomaly
– A market phenomenon that cannot be explained by standard asset
pricing theory
– Examples: momentum (above average performance of short-term
winners), bubbles,…
Psychology
– Documents many individual deviations from rational expected utility
maximization
– Example: give too much weight to recent information (=> overreaction
to news)
If you haven‘t already done so, it‘s now a good time to read
Psychological underpinnings
– Belief in trends even if clearly there are none
– Biased self-attribution: neglect information that questions the validity of
one’s beliefs or actions
– Representative heuristic: judge things based on their similarity with
what is regarded as typical
Applied to internet:
– Price increases lead to further increases due to extrapolation
– Disregard indicators of overvaluation (P/E ratios,…)
– Get fooled (Pay more for a stock just because a dotcom was added to
the name…)
Can of course be mixed with other elements:
– Greed
– Fraud
– …
Some evidence shows that even experts are prone to irrational biases
(other evidence, however, shows that successful people are less so)
Limits of arbitrage: Even if there are smart investors around, they do not
bring prices to their correct level because of
– Short sale constraints
– Risk of arbitrage
Problem 13
(6,000, .25) or (4,000, .25; 2,000, .25)
[18] [82]
Problem 13‘
(-6,000, .25) or (-4,000, .25; -2,000, .25)
[70] [30]
v(x)
Problem 14
(5,000, .001) or (5)
[72] [28]
Problem 8
(6,000, .001) or (3,000, .002)
[73] [27]
Problem 1
(2,500, .33; 2,400, .66) or (2,400)
[18] [82]
Problem 2
(2,500, .33) or (2,400, .34)
[83] [17]
Consider a reference point that is linked to past values, e.g. the price at
which an investor bought shares, or the values from the end of last year.
Whether a situation is considered as a gain or loss then depends on recent
performance, and so will risk aversion.
The term yield is often used to denote the percentage cash return to the
owners of an asset. Examples:
– Dividend yield: Let the price of a stock be 50. It will pay a dividend of
0.75. The dividend yield is then 0.75/50 = 1.5%
– Bond yield: Let the price of a bond maturing in one year be 95. In one
year, it pays a coupon of 4 plus the principal of 100. The bond yield is
then 104/95 – 1 = 9.47%
Also called: yield to maturity or redemption yield. A bit more complex
to determine if the bond matures not in one year. The yield is then the
r that solves
T
Coupon t Principal
p0 =
t =1 (1 r ) t (1 r )T
Short selling: sell a stock or another asset that you do not possess
How does it work?
– Find an institution or individual willing to lend you the stock
– Sell the stock on the stock market
– Post the proceeds as collateral with the lender
– Buy the stock at some later time, return it to the lender and receive the
collateral + rebate rate
– The rebate rate is lower than the market interest rate which means that
the lender gets a compensation for lending
Stock has to be returned when the lender recalls it or on a termination date
(if agreed)
Why does one want to sell short: benefit from falling stock prices, hedging
An investor holding a stock over one period return gets (p=stock price,
d=dividend) the following return:
pt d t
Rt = (1 rt ) =
pt 1
=> For determining the return we therefore need prices and dividends.
We can chain returns together like we’ve seen before
R0,T = R1R2R3….RT
One usually talks about mean returns:
1 T
arithmetic mean: R = Rt
T t =1
T 1/ T
geometric mean:
RG = Rt
t =1
Asset Pricing 125
Measuring rates of return on the stock market (2): indices
A stock market index groups several stocks together. The index value
tracks the average price of the stocks
Important indices
– S&P 500 (500 large US stocks)
– Dow Jones (30 large US stocks)
– DAX (30 large German stocks)
Large is usually defined via market capitalization of a company
(= price per share times number of shares issued)
To calculate average price, index components are mostly weighted
according to market capitalization
Bond indices and other indices can be constructed in a similar fashion
Stocks and other assets are risky. So it’s interesting to compare their
returns to the safe alternative.
The difference between the return on a risky asset R and the risk-free
return Rf is called excess return or risk premium
The average risk premium of stocks is called equity premium
To determine Rft we can:
– take the interest rate prevailing at t-1 for [t-1, t]
– take the return [t-1, t] on an index containing risk-free bonds
Note that earnings in t are not the same as the payoffs that shareholders
receive in t because some part of earnings are not immediately paid out as
dividends. They may be paid out in a later year t, but then they become
payoffs in year t, not in t
In some areas – especially when talking about investments of firms – we
would say cash flow instead of payoff but mean the same thing: it’s money
that a firm or an investor gets
If accounting is such that all changes to book value other than ownership
transactions are reflected in earnings,we get the clean surplus relation:
1 T
Autocorrelation of order j: X t X X t j X
T 1 t =1 j
s X2
N N
Note: s = aij wi w j
j =1 i =1
N N
s
Differentiate with respect to the kth element of w: w = akj w j aik wi
k j =1 i =1
s
Which for symmetric matrices simplifies to: = 2 Aw
w irm 133
The lognormal distribution
-5 -4 -3 -2 -1 0 1 2 3 4 5 0 2 4 6 8 10
ln(X) X
f ( x1 ) = f ( x0 ) f ' ( x0 )( x1 x0 )
1
f ( x1 ) = f ( x0 ) f ' ( x0 )( x1 x0 ) f ' ' ( x0 )( x1 x0 ) 2
2
Proof:
Pr ( F-1 (U) ≤ x ) = Pr ( U ≤ F(x) ) = F(x)
136
Some hints for EXCEL