FINANCIAL ECONOMICS (金融经济学大纲)

Ignacio Palacios-Huerta E CONOMICS244

MW

Economics

8:30-9:50 of

Department

2002 University Spring

Brown

FINANCIAL ECONOMICS

This course is intended for Ph.D. students interested in economics and finance. The course presumes previous exposure to undergraduate economics, econometrics and statistics. The accent and intent of this course is to take the student to the frontier of our knowledge in theoretical and, especially, empirical asset pricing finance and to let him/her understand and enjoy the exciting time that academic researchers and high-tech practitioners in this area are enjoying right now. Over the last decade much progress has been made to answer the fundamental questions in macroeconomics and finance. However, the central task of absolute asset pricing finance, which is to understand and measure the sources of aggregate or macroeconomic risk that drive asset prices, is unfinished. Although much empirical work has documented tantalizing stylized facts and links between economic variables and finance, the theory lags behind and we do not have yet a complete model that explains, as opposed to describes, the rich body of empirical evidence. Novel theories and empirical work are subject to a great demand in this field.

The course is stated mostly in a discount factor language and is often translated in the traditional expected return-beta or mean-variance language. The major advantages of this approach, common in current academic research, are its universality and simplicity. The accent of the course is on understanding statements of theory, and working with that theory to applications, rather than rigorous or general proofs. The course focuses, in its second part, on current academic research and thus offers a fertile ground of ideas for students that are or may be interested in doing graduate thesis in finance, microeconomics (preference formation), macroeconomics, international economics and applied econometrics dissertation topics. The course goes very lightly over many parts of asset pricing theory that have faded from current applications and are not a cornerstone of modern asset pricing, although they occupied large amounts of attention in the past.

Lecture Notes and Readings. The initial part of the course is based on lecture notes. I will distribute most of my own notes. The rest of the course is highly intensive in reading and evaluating several academic papers. Those marked with an asterisk (*) in the enclosed list are required readings for a complete understanding of all material covered in the course. All others are suggested and intended to be additional references to various parts of the course. As the course goes along other relevant papers may be distributed either as required or suggested readings.

No single book covers the material in this course. However, various chapters of the book by John Campbell, Andrew Lo and A.C. MacKinlay, The Econometrics of Financial Markets, Princeton University Press, 1997, are directly related to various parts of the course. In any event, it is an excellent book worth owning. The book Asset Pricing, by John Cochrane, Princeton University Press, 2001, is highly recommended. It will be particularly useful for the first part of the course.

SYLLABUS

The accent of the course is on understanding the fundamental implications of finance theory, and working with that theory to applications, rather than rigorous or general proofs. Applications and empirical evidence will be emphasized. Basic fundamentals (especially in parts I and II) are thoroughly discussed in lectures notes that will be distributed during the course. The structure of the course is the following:

Part I. DISCRETE TIME ASSET PRICING THEORY - WEEKS 1-2

1. Consumption-Based Model

a. Basic Pricing Equation

b. Marginal Rate of Substitution / Stochastic Discount Factor

c. Consumption-Based Model in Practice

d. Alternative Asset Pricing Models: Overview

2. The Discount Factor

a. Contingent Claims

b. Law of One Price

c. No-Arbitrage and Positive Discount Factors

3. Mean-Variance Frontier and Beta Representations

a. Expected Return - Beta Representations

b. Mean-Variance frontiers

c. Relation between p = E(mx), beta and mean-variance frontiers

4. Implications of Existence and Equivalence Theorems

a. Discount Factors vs. Mean, Variance and Beta

5. Conditioning Information

a. Conditioning Information in Returns

b. Adding Scaled returns

c. Conditional and Unconditional Models

6. Factor Pricing Stories (*)

a. Capital Asset Pricing Model (CAPM)

b. Intertemporal Capital Asset Pricing Model (ICAPM)

c. Comments on CAPM and ICAPM

d. Arbitrage Pricing Theory (APT)

e. ICAPM vs. APT

Part II. INITIAL EMPIRICAL SURVEY -- WEEK 3

1. Return Predictability

2. Present Value Tests

3. Factor Pricing Models

a. The CAPM

b. Chen-Roll-Ross Model

c. Investment and Macroeconomic Factors

d. Book to Market

4. Consumption-Based Model Tests

a. CRRA Utility

b. Durable Goods and Habits

c. State-nonseparabilities

Part III. HANSEN-JAGANNATHAN BOUNDS FOR DIAGNOSING ASSET

PRICING MODELS – WEEK 4

1. The Basic HJ Bound

2. Many Returns-Formulas. Results

4. Beyond Mean and Variance

5. Diagnostic Tests. Comments

7. HJ Bounds with Frictions

8. The Comparison of HJ bounds

Part IV. ESTIMATING AND TESTING DISCRETE-TIME MODELS –WEEK 5

1. General Method of Moments (GMM) Estimation and Testing of Asset Pricing Models

a. GMM in Explicit Discount Factor Models

b. Applying GMM to Linear Factor Models

c. Other Uses of GMM

2. Diagnostic and Specification Calculations (*)

a. Horse Races

b. Prespecified Weighing Matrices

c. Testing Moments

3. Regression-Based Tests (*)

Part V. ASSET PRICING PUZZLES -- WEEKS 6-9

1. The Returns of Stocks and Bonds

2. The Equity Premium Puzzle

3. The Risk-Free Rate Puzzle

4. The Stockholding Puzzle

5. Home Bias and the International Diversification Puzzle

6. Some “Partial” Solutions:

a. “Preference” Solutions (Habits and Durability, “Catching-Up with the Joneses,”

“The Spirit of Capitalism,” Epstein-Zin Recursive Preferences, Campbell-

Cochrane “moving” habits)

b. “Budget Constraints” Solutions (Liquidity Constraints, Borrowing Constraints,

Short-Sale Constraints, Transaction Costs and Incomplete Markets)

c. Individual Heterogeneity

d. The Role of other Assets

7. Some Important Considerations

a. The Horizon of the Analysis

b. Who Holds Financial Assets?

c. The Consumption and Assets of Stockholders

d. Who should hold financial assets (and which ones)?

Part VI. CURRENT AND RECENT TOPICS IN ASSET PRICING FINANCE

– WEEKS 10-12

1. Human Capital Risk and Returns

a. Measurement and Pricing of Human Capital Assets

b. Human Capital and the Market Return

c. Jagannathan-Wang Conditional CAPM with Human Capital

e. Campbell’s Risk and Return

e. Human Capital and Asset Pricing Puzzles

2. Behavioral Finance

a. Behavioral Anomalies, Paradoxes and Human Nature

b. Loss Aversion, Disappointment Aversion, Knightian Uncertainty Aversion

c. Hyperbolic vs. Exponential vs. Endogenous Time Discounting

d. Behavioral Anomalies and Asset Pricing Puzzles

e. Prospect Theory and Asset Prices

3. Robustness in Macroeconomics and Finance.

Part VII. OTHER TOPICS (*)

For example:

1. Financial Structure and Risk Sharing

2. Endogenous Risk and Financial Innovations

3. Globalization and Stock Exchange Competition

(*) Some of these topics may be covered if time allows.

READING LIST

*Abel, Andrew B., “Asset prices under habit formation and catching up with the Joneses,” American

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Aiyagari, S. Rao and Mark Gertler. “Asset Returns With Transactions Costs And Uninsured Individual Risk,” Journal of Monetary Economics, 1991, 27(3), 311-332.

*Allais, Maurice “Le Comportement de l’Homme Rationnel devant le Risque: Critiques des Postulats et Axioms de l’Ecole Americaine,” Econometrica 21, 503-546.

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*Bakshi, G., and Z. Chen, 1996, “The Spirit of Capitalism,” American Economic Review, March, 133-157. *Brav, A. and C. Geczy, 1996, “An Empirical Resurrection of the Simple Consumption CAPM with Power Utility,” working paper, University of Chicago.

Burnside, C., 1994, “Hansen-Jagannathan Bounds as Classical Tests of Asset-Pricing Models,” Journal of Business and Economic Statistics, 1994, 12, 1, 57-79.

Barberis, Nicholas, “Investing for the long run when returns are predictable,” University of Chicago,

Center for Research on Security Prices, working paper, No. 439, 1997.

Barberis, Nicholas, 1996, “How Big Are Hedging Demands? Evidence from Long-Horizon Asset Allocation,” unpublished paper, Harvard University, Cambridge, MA.

*Barberis, N., Huang, M. and J. Santos, 1999, “Prospect Theory and Asset Prices,” Forthcoming QJE.

*Barsky, Robert B., Miles S. Kimball, F. Thomas Juster, and Matthew D. Shapiro, “Preference parameters and behavioral heterogeneity: An experimental approach in the health and retirement survey,”

Quarterly Journal of Economics, May 1997.

*Basak, S. and D. Cuoco, 1997, “An Equilibrium Model with Restricted Stock Market Participation,”

Rodney L. White Center for Financial Research, Working Paper 001-97.

*Baxter, Marianne, and Jermann, Urban. “The International Diversification Puzzle Is Worse than You

Think.” American Economic Review, March 1997, 87(1), pp. 170-80.

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*Blanchard, O. J., 1993, “Movements in the Equity Premium,” Brookings Papers on Economic Activity, 2, 1993, 75-138.

*Bertaut, Carol C. “Who Holds Stock in the U.S.?: An Empirical Investigation,” University of Maryland, Revised December 1992.

*Blume, Marshall E., and Stephen P. Zeldes, “The Structure of Stockownership in the U.S.”, Manuscript, The Wharton School, University of Pennsylvania, March 1993.

Bodie, Zvi, Robert C. Merton and William F. Samuelson. “Labor Supply Flexibility and Portfolio Choice In

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Campbell, J. Y. and L. M. Viceira, 1996, “Consumption and Portfolio Decisions When Expected Returns are Time Varying,” NBER Working Paper 5857. Forthcoming QJE 2000.

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*________, Asset Pricing, Princeton University Press, 2001.

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________. “Business Conditions and Expected Returns on Stocks and Bonds.” Journal of Financial Economics 25 (November 1989): 23-49.

*________. “The Cross-Section of Expected Stock Returns.” Journal of Finance 47 (June 1992): 427-65. ________. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Econ. 33 (February 1993): 3-56.

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