Preface
1. Asset pricing theory tries to understand the prices or values of claims to uncertain payments. A low price implies a high rate of return, so one can also think of the theory as explaining why some assets pay higher average returns than others.
2. To value an asset, we have to account for the delay and for the risk of its payments. The effects of time are not too difficult to work out. However, corrections for risk are much more important determinants of an many assets’ values. For example, over the last 50 years U.S. stocks have given a real return of about 9% on average. Of this, only about 1% is due to interest rates; the remaining 8% is a premium earned for holding risk. Uncertainty, or corrections for risk make asset pricing interesting and challenging.
3. Price equals expected discounted payoff. Two approaches to elaboration - Absolute pricing and Relative pricing
4. Absolute pricing, we price each asset by reference to its exposure to fundamental sources of macroeconomic risk. The CAPM and its successor factor models are paradigms of the absolute approach.
5. Relative pricing, We ask what we can learn about an asset’s value given the prices of some other assets. We do not ask where the price of the other set of assets came from, and we use as little information about fundamental risk factors as possible. Black-Scholes option pricing is the classic example of this approach.
6. The central and unfinished task of absolute asset pricing is to understand and measure the sources of aggregate or macroeconomic risk that drive asset prices
7. Two pricing equations pt = E(mt+1xt+1) mt+1 = f(data, parameters) where pt = asset price, xt+1 = asset payoff, mt+1 = stochastic discount factor
8. The major advantage of the discount factor / moment condition approach are its simplicity and universality
9. The hurdles in asset pricing are really conceptual rather than mathematical.
Chapter 1. Consumption-based model and overview
1. The interest rate is related to the average future marginal utility, and hence to the expected path of consumption. High real interest rates should be associated with an expectation of growing consumption. In a time of high real interest rates, it makes sense to save, buy bonds, and then consume more tomorrow.
2. Fundamental point of the whole book - Risk corrections to asset prices should be driven by the covariance of asset payoffs with consumption or marginal utility. For a given expected payoff of an asset, an asset that does badly in states like a recession, in which the investor feels poor and is consuming little, is less desirable than an asset that does badly in states of nature like a boom when the investor feels wealthy and is consuming a great deal. The former assets will sell for lower prices; their prices will reflect a discount for their riskiness, and this riskiness depends on a co-variance.
1. Real interest rates are high when people are impatient, when β is low. If everyone wants to consume now, it takes a high interest rate to convince them to save.
2. Real interest rates are high when consumption growth is high. In times of high interest rates, it pays investors to consume less now, invest more, and consume more in the future. Thus, high interest rates lower the level of consumption today, while raising its growth rate from today to tomorrow.
3. Real interest rates are more sensitive to consumption growth if the power parameter γ is large. If utility is highly curved, the investor cares more about maintaining a consumption profile that is smooth over time, and is less willing to rearrange consumption over time in response to interest rate incentives. Thus it takes a larger interest rate change to induce him to a given consumption growth.
1. Asset pricing theory tries to understand the prices or values of claims to uncertain payments. A low price implies a high rate of return, so one can also think of the theory as explaining why some assets pay higher average returns than others.
2. To value an asset, we have to account for the delay and for the risk of its payments. The effects of time are not too difficult to work out. However, corrections for risk are much more important determinants of an many assets’ values. For example, over the last 50 years U.S. stocks have given a real return of about 9% on average. Of this, only about 1% is due to interest rates; the remaining 8% is a premium earned for holding risk. Uncertainty, or corrections for risk make asset pricing interesting and challenging.
3. Price equals expected discounted payoff. Two approaches to elaboration - Absolute pricing and Relative pricing
4. Absolute pricing, we price each asset by reference to its exposure to fundamental sources of macroeconomic risk. The CAPM and its successor factor models are paradigms of the absolute approach.
5. Relative pricing, We ask what we can learn about an asset’s value given the prices of some other assets. We do not ask where the price of the other set of assets came from, and we use as little information about fundamental risk factors as possible. Black-Scholes option pricing is the classic example of this approach.
6. The central and unfinished task of absolute asset pricing is to understand and measure the sources of aggregate or macroeconomic risk that drive asset prices
7. Two pricing equations pt = E(mt+1xt+1) mt+1 = f(data, parameters) where pt = asset price, xt+1 = asset payoff, mt+1 = stochastic discount factor
8. The major advantage of the discount factor / moment condition approach are its simplicity and universality
9. The hurdles in asset pricing are really conceptual rather than mathematical.
Chapter 1. Consumption-based model and overview
1. The interest rate is related to the average future marginal utility, and hence to the expected path of consumption. High real interest rates should be associated with an expectation of growing consumption. In a time of high real interest rates, it makes sense to save, buy bonds, and then consume more tomorrow.
2. Fundamental point of the whole book - Risk corrections to asset prices should be driven by the covariance of asset payoffs with consumption or marginal utility. For a given expected payoff of an asset, an asset that does badly in states like a recession, in which the investor feels poor and is consuming little, is less desirable than an asset that does badly in states of nature like a boom when the investor feels wealthy and is consuming a great deal. The former assets will sell for lower prices; their prices will reflect a discount for their riskiness, and this riskiness depends on a co-variance.
1. Real interest rates are high when people are impatient, when β is low. If everyone wants to consume now, it takes a high interest rate to convince them to save.
2. Real interest rates are high when consumption growth is high. In times of high interest rates, it pays investors to consume less now, invest more, and consume more in the future. Thus, high interest rates lower the level of consumption today, while raising its growth rate from today to tomorrow.
3. Real interest rates are more sensitive to consumption growth if the power parameter γ is large. If utility is highly curved, the investor cares more about maintaining a consumption profile that is smooth over time, and is less willing to rearrange consumption over time in response to interest rate incentives. Thus it takes a larger interest rate change to induce him to a given consumption growth.