THE JOURNAL OF FINANCE

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THE JOURNAL OF FINANCE . VOL. LVII, NO. 4 . AUGUST 2002

Rational Asset Prices

GEE M. CONSTANTINIDES*

ABSTRACT

The mean, covariability, and predictability of the return of different classes of

financial assets challenge the rational economic model for an explanation. The unconditional mean aggregate equity premium is almost seven percent per year

and remains high after adjusting downwards the sample mean premium by introducing prior beliefs about the stationarity of the price–dividend ratio and the ~non!forecastability of the long-term dividend growth and price–dividend ratio. Recognition

that idiosyncratic ine shocks are uninsurable and concentrated in recessions contributes toward an explanation. Also borrowing constraints over the investors’

life cycle that shift the stock market risk to the saving middle-aged consumers contribute toward an explanation.

A central theme in finance and economics is the pursuit of a unified theory

of the rate of return across different classes of financial assets. In particular,

we are interested in the mean, covariability,and predictability of the return

of financial assets. At the macro level, we study the short-term risk-free

rate, the term premium of long-term bonds over the risk-free rate, and the

aggregate equity premium of the stock market over the risk-free rate. At

the micro level, we study the premium of individual stock returns and of

classes of stocks, such as the small-capitalization versus large-capitalization

stocks, the ―value‖ versus ―growth‖ stocks, and the past losing versus winning stocks.

The neoclassical rational economic model is a unified model that views

these premia as the reward to risk-averse investors that process information

rationally and have unambiguously defined preferences over consumption that

typically ~but not necessarily!

belong to the von Neumann–Menstern class.

Naturally, the theory allows for market inpleteness, market imperfections, informational asymmetries, and learning. The theory also allows for

differences among assets for liquidity, transaction costs, tax status, and other institutional factors.

The cause of much anxiety over the last quarter of a century is evidence

interpreted as failure of the rational economic paradigm to explain the price

level and the rate of return of financial assets both at the macro and micro

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