Microfoundations of Financial Economics 2004-2005 1.1 Empirical challenges

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Microfoundations of Financial Economics2004-2005
1.1 Empirical challenges

• Professor André Farber
• Solvay Business School
• Université Libre de Bruxelles

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Theory of asset pricing under certainty
1930
FisherTheory of Interest
WilliamsTheory of Investment Value
1940
1950
HirshleiferTheory of Optimal Investment Decisions
1960
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Theory of asset pricing under uncertainty
1950
ArrowState prices
MarkowitzPortfolio theory
1960
Arrow DebreuGeneral equilibrium
Sharpe LintnerCAPM
1970
Black Scholes MertonOPM
RossAPT
LucasAsset Prices
RossRisk neutral pricing
VasiceckTerm structure
Harrison KrepsMartingales
Cox Ross RubinsteinBinomial OPM
1980
Theoretical developments in the period since
1979, with relatively few exceptions, have been a
mopping-up operation. Duffie,D. Dynamic Asset
Pricing Theory, 3d ed. Princeton Universiy Press
2001
1990
Cochrane Campbell p E(MX)
2000
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Three views of asset pricing
General equilibrium
Mean variance efficiency
Stochastic discount factors
Beta pricing
Factor modelNo arbitrage
Risk-neutral pricing
State priceslinear pricing rule
Complete marketsNo arbitrage (NA)Law of one
price (LOOP)
Adapted from Cochrane Figure 6.1
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Old finance

• 1. CAPM
• Only systematic risk (beta) matters
• High average returns are associated with high
  betas
• Nothing else matters
• 2. Returns are unpredictable
• Stocks Random Walk Efficient market hypothesis
• Bonds Expectation model of the term structure
• Foreign exchange

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For practitioners

• Calculate NPV using the CAPM for calculating the
  cost of capital
• What is the proper risk free rate?
• Uses constant market risk premium
• Assumes constant beta
• otherwise
• Option pricing model
• Invest in the market portfolio

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Empirical challenges

• Explaining the cross section of returns
• Explaining changes in expected returns

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Beta
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Size and B/M
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Based on monthly data 192607 200411 File
25_Portfolios_5x5_monthly.xls
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Fama French
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Predictability Interest Rates and Expected
Inflation
Sample period (Sample Size) ?
1831-2002 (2,053) -2.073(-3.50)
1831-1925 (1,136) -3.958(-4.58)
1926-1952 (324) 0.114(0.03)
1953-1971 (228) -5.559(-2.57)
1972-2002 (357) -1.140(-1.08)
Schwert, W., Anomalies and Market Efficiency,WP
October 2002 http//ssrn.com/abstract_id338080
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Predictability D/P
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Predictability
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Econometrician wanted