Asset Pricing: Prof. Lutz Hendricks

Asset pricing
Prof. Lutz Hendricks
November 17, 2010
L. Hendricks () Asset pricing November 17, 2010 1 / 49

Issues
1 What determines the rates of return / prices of various assets?

2 How can risk be measured and priced?
We use the Lucas fruit tree model.

The implications are far more general than the simple model.

The Lucas Fruit Tree Model
We study the model introduced by Lucas (1978).

Agents:
A single representative household.
Preferences:
∞
max E0 ∑ β t u ( ct ) (1)
t =0
E0 is the expectation as of time t = 0.

The Model
Technology
This is an endowment economy.

There are K identical fruit trees.
Each tree yields dt units of consumption goods in period t.
dt is random and the same for all trees.
Trees cannot be produced.
Fruits cannot be stored.

The Model
Technology
The aggregate resource constraint:
ct = Kdt (2)
Assume that d is a …nite Markov chain with transition matrix

π (d 0 , d ).
An important feature: All uncertainty is aggregate.
There are no opportunities for households to insure each other.
This is why we can work with a representative household.

The Model
Markets
There are markets for fruits and for trees.

There is also a one period bond, issued by households (in zero net
supply).
Its purpose is to determine a risk-free interest rate.

Household problem
The household starts out with bonds (b0 ) and shares (k0 ).
At each date, he chooses ct , bt +1 , kt +1 .
The budget constraint is
pt kt +1 + bt +1 = Rt bt + (pt + dt ) kt ct (3)
Notation:
p : the price of trees. Suppressing dependence on the state.
R : the real interest rate on bonds.
the price of bonds is normalized to 1 (how?).

Household problem
V (k, b, d ) = max u (c ) + βEV k 0 , b 0 , d 0 (4)

subject to
Rb + (p + d ) k c + pk 0 b0 = 0 (5)

Household problem
First-order conditions:
c : u 0 (c ) = λ
k 0 : λp = EVk (k 0 , b 0 , d 0 )
b 0 : λ = EVb k 0 , b 0 , d 0
Envelope:
Vk = λ (p + d )
Vb = λR

Household problem
Euler equations
u 0 (ct ) = β Et u 0 (ct +1 ) Rt +1
pt +1 + dt +1
= β Et u 0 ( c t + 1 )
pt

Household problem
Solution
A solution consists of state contingent plans fc (d t ) , k (d t ) , b (d t )g

for all histories d t .
These satisfy:
2 Euler equations
1 budget constraint.
b0 and k0 given.
Transversality: limt !∞ E0 βt u 0 (ct ) [bt + pt kt ] = 0.

Market clearing
For every history we need:

Bonds:
bt = 0
Trees:
kt = Kt
Goods:
ct = Kt dt
There is no trade in equilibrium!

Competitive Equilibrium
A CE consists of:
1 an allocation: fc (d t ) , b (d t ) , k (d t )g.
2 a price system: fp (d t ) , R (d t )g
These satisfy:
1 household: 2 Euler equations and 1 budget constraint.
2 3 market clearing conditions.

Recursive Competitive Equilibrium
Objects:
Solution to the household problem: V (k, b, d ) and c (k, b, d ),
k 0 = κ (k, b, d ), b 0 = B (k, b, d ).
Price functions: p (d ) , R (d ).
Equilibrium conditions:
Household: 4
Market clearing: 2
No need for consistency: law of motion of the aggregate state is
exogenous.

Consumption smoothing
The Euler equation implies (for any asset):
βu 0 (ct +1 )
Et Rt +1 =1 (6)
u 0 ( ct )
De…ne: Marginal rate of substitution:

MRSt +1 = β u 0 (ct +1 )/u 0 (ct ) (7)
MRSt +1 is inversely related to consumption growth.

1 σ
With u (c ) = c1 σ :
u 0 (c ) = c σ
(8)
σ
MRSt +1 = β (ct +1 /ct ) (9)
With constant R, the household chooses constant consumption

growth.
The coe¢ cient of relative risk aversion (σ) determines how much
MRS ‡uctuates with c.
High σ implies that the household chooses smooth consumption.
Illustration for the deterministic case:
ct+1/ct
Low σ
High σ
Rt+1
With high σ, marginal utility changes a lot when c changes.

The household then keeps c smooth.
ct+1
High σ
Low σ
ct

Asset pricing implications
We will now derive the famous Lucas asset pricing equation.

De…ne: Rate of return on trees: RtS+1 = (pt +1 + dt +1 ) /pt .
Directly from the 2 Euler equations:
βu 0 (ct +1 ) βu 0 (ct +1 ) S
Et Rt +1 = Et Rt +1 =1
u 0 ( ct ) u 0 ( ct )
Or n o
E fMRSt +1 Rt +1 g = E MRSt +1 RtS+1 = 1 (10)

When does an asset pay a high expected return?
Re-write asset pricing equation using
Cov (x, y ) = E (x y ) E (x ) E (y )
as
1 = E fMRS g E fR g + Cov (MRS, R )

1 Cov (MRS, R )
E (R ) = (11)
E (MRS )

When do assets pay high returns?
1 Cov (MRS, R )
E (R ) = (12)
E (MRS )
High returns require low Cov (MRS, R ).

With CRRA utility: high MRS means low consumption growth.
Therefore: Assets pay high returns if their returns are positively
correlated with consumption growth.

When do assets pay high returns?
Intuition
Imagine there are good times (high c) and bad times (low c).
There are 2 assets: A pays dividends in good times, B pays in bad
times.
The value of the dividend is u 0 (c ).
Assets that pay in good times are not valuable: u 0 (c ) is low.
Assets that pay in bad times provide insurance - they are valuable
(have low expected returns).

Risk (premia)
The "risk free" assets has expected return
1
E (Rf ) = (13)
E (MRS )
A "risky" asset has expected return

1 Cov (MRS, R )
E (R ) = (14)
E (MRS )
The risk premium is

Cov (MRS, R )
E (R ) E (Rf ) = (15)
E (MRS )
This de…nes what risk means: covariance with consumption

growth.
Note that risk can be negative (insurance).
The Equity Premium Puzzle
Mehra and Prescott (1985): Asset return data pose a puzzle for the
theory.
The equity premium is "high" (6-7% p.a.)
The cov of c growth and Rs is low.
The reason: Consumption is very smooth.

Kocherlakota (1996)

A back-of-the envelope calculation with CRRA utility:
Cov β [ct +1 /ct ] σ , Rs

EP = n o (16)
σ
E β [ct +1 /ct ]
Take log utility: σ = 1.

Cov (MRS, Rs ) ' 0.0022.
E (MRS ) ' 1.
EP ' 0.2%.
Replicating the observed equity premium requires very high risk
aversion (σ = 40).

How severe is the puzzle?
Investors forego very large returns.
Mehra & Prescott (2003)

Long holding periods
Over 20 year holding periods: stocks dominate bonds.
Mehra & Prescott (2003)

Why do we care?
The EP puzzle shows that we do not understand

1 what households view as "risky"
2 why households place a high value on smooth consumption
This has implications for:
1 The welfare costs of business cycles
They are very low in standard models.
2 Stock price volatility.
Standard models fail to explain it (see below).

How to resolve the puzzle
Proposed explanations include:

[ct γct 1 ]1 σ
1 Habit formation: u (ct , ct 1) = 1 σ .
Implies high risk aversion when ct is close to ct 1.
2 Heterogeneous agents
Implicit in the standard model: all idiosyncratic risk is perfectly insured.
3 Borrowing constraints
The young should hold stocks (long horizon), but cannot.
The old receive mostly capital income and …nd stocks risky.
4 Taxes / regulations (McGrattan & Prescott 2001)
The runup in stock prices since the 1960s stems from lower dividend
taxes & laws permitting institutional investors to hold equity.

Beta
Now we derive the famous "beta" measure of risk.

Suppose asset m (the market) is perfectly correlated with marginal
utility:
u 0 (ct +1 ) = γ Rm,t +1 (17)
The market’s expected return is
Cov (MRS, Rm )
E Rm R= (18)
E (MRS )

Beta
Now we relate the covariance term to marginal utility:
u 0 ( ct + 1 ) Cov (u 0 (ct +1 ) , Rm,t +

Cov (MRS, Rm ) = Cov , Rm,t +1 = (1
u 0 ( ct ) u 0 ( ct )
E (u 0 (ct +1 ))
E (MRS ) = (2
u 0 ( ct )
Therefore:
Cov (u 0 (ct +1 ) , Rm,t +1 ) γ Var (Rm,t +1 )
E (Rm ) R= = (21)
E u 0 ( ct + 1 ) E u 0 ( ct + 1 )

Beta
For any asset i:
Cov (u 0 (ct +1 ) , Ri ) γ Cov (Rm , Ri )

E Ri R= 0
= (22)
E u ( ct + 1 ) E u 0 ( ct + 1 )
Take the ratio for assets i and m:
E Ri R = βi [E Rm R ]
Cov (Rm , Ri )
βi =
Var (Rm )
This is the famous CAPM asset pricing equation.

Beta
The risk premium for asset i depends on:

it’s beta (essentially the correlation with the market)
the market price of risk: E Rm R.
A stock’s beta can be estimated from data on past returns of the
stock (Ri ) and the market (using a broad stock index).
Betas are used to
Measure the risk of an asset.
Calculate the required rate of return for investment projects.
Evaluation of mutual fund managers.

Securities market line
In equilibrium, all asset returns line up on the SML.
Perold (2004)
Securities market line: Evidence
Stocks with higher βs have higher expected returns, but not enough.
Fama (2004)
Solving for the asset price
We show that the asset price equals the present discounted value of
dividends.
Start from the Euler equation:
pt +1 + dt +1
u 0 ( c t ) = β Et u 0 ( ct + 1 ) (23)
pt
Solve for the price:

β u 0 ( ct + 1 )
pt = Et (pt +1 + dt +1 ) (24)
u 0 ( ct )
Replace pt +1 with (24) shifted to t + 1:
β u 0 ( ct + 1 )
pt = Et dt +1 +
u 0 ( ct )
β u 0 ( ct + 1 ) β u 0 ( ct + 2 )
Et E t + 1 (pt +2 + dt +2 ) (25)
u 0 ( ct ) u 0 ( ct + 1 )
The law of iterated expectations:
Et fEt +1 (x )g = Et (x ) (26)
Eliminate the Et +1 :
( )
β u 0 ( ct + 1 ) β 2 u 0 ( ct + 2 )
pt = E t dt +1 +E t (pt +2 + dt +2 ) (27)
u 0 ( ct ) u 0 ( ct )
Iterate forward for T periods:

( )
T
β j u 0 ( ct + j )
pt = E t ∑ dt +j (28)
j =1 u 0 ( ct )
( )
β T + 1 u 0 ( ct + T + 1 )
+E t (pt +T +1 + dt +T +1 ) (29)
u 0 ( ct + T )

Impose that the last term vanishes in the limit:

( )
∞
β j u 0 ( ct + j )
pt = E t ∑ dt +j (30)
j =1 u 0 ( ct )
There is no good reason for this assumption!

The asset price equals the discounted present value of dividends.
The stochastic discount factor is the marginal rate of substitution.

Example: Log Utility
In the Lucas model, assume: u (c ) = ln(c ). K = 1.

In equilibrium: ct = dt .
β u 0 (c t +1 ) β dt
MRSt +1 = u 0 (c t )
= d t +1 .
The asset pricing equation becomes
( )
∞
βj dt
pt = Et ∑ dt +j
dt +j
j =1
β
= dt
1 β

Example: Periodic dividends
In the Lucas model, assume:

Utility is u (c ) = c 1 σ /(1 σ).
dt alternates between d H and d L .
Asset pricing equation:
∑ βj dt /dt +j
σ
pt = dt +j (31)
= dtσ ∑ βj dt1+jσ
On good days, pt is pulled up by low u 0 (c 0 ), but is pushed down by

low dt +1 .

The Excess Volatility Puzzle
Consider a stock with dividend process dt .

Its price is given by
( )
∞
β j u 0 ( ct + j )
pt = E t ∑ u 0 ( ct )
dt +j (32)
j =1
In the data:
Dividends are very smooth (a goal of company policy).
Stock prices are much more volatile than dividends.
But in the theory: stock prices should be the average of future
dividends and thus smoother than dividends.
This is the ‡ip-side of the Equity Premium Puzzle.

Bubbles
Recall how the asset pricing formula is derived:

We iterate forward on the asset pricing Euler equation
β u 0 ( ct + 1 )
pt = Et (pt +1 + dt +1 ) (33)
u 0 ( ct )
We assume that the pt +1 term vanishes in the limit.

What if it does not vanish?
Then any (current) asset price can satisfy the asset pricing equation.
The deviation between pt and the fundamental price from (33) is
called a bubble.
It is purely a self-ful…lling expectation.

Bubbles: Example
Consider an asset that pays no dividends.

Its fundamental price is 0.
β u 0 (c t +1 )
Assume that the MRS is constant at u 0 (c 1 )
= 1.
The the asset pricing equation is
pt = Et pt +1 (34)
One price process that satis…es this: p doubles with probability 1/2
and drops to 0 otherwise.
This satsi…es (34) for any pt .
Bubbles are a possible explanation for asset price volatility.
Note that the bubble does not o¤er any excess return opportunities.

State contingent claims
Some assets pay out only in particular states of the world

e.g. insurance contracts
Standard asset pricing formulas apply to those assets.
It just adds notation...

State contingent claims
We start from the Lucas fruit tree model.

In addition to stocks and bonds, households can purchase assets that
pay out in exactly one state of the world.
Notation:
quantity purchased of asset that pays out in state d 0 : y 0 (d 0 ).
price of that asset: q (d 0 jd ).

Household
states: all assets held, k, b, and all y (d ).

choices: b 0 , k 0 , y (d 0 ).
Dynamic Program:
V (k, b, y (1) , ..., y (N ) , d ) = max u (c ) (35)

0 0 0 0
d0
+ βEV k , b , y (1) , ..., y (N ) ,(36)
subject to
Rb + (p + d ) k + y (d ) = c + b 0 + pk 0 + ∑ q d 0 jd y0 d0 (37)
d0

First-order conditions for state contingent claims
u 0 (c ) q d 0 jd = β Pr d 0 jd Vy (d 0 ) k 0 , b 0 , y 0 (1) , ..., y 0 (N ) , d 0 (38)
Envelope:
Vy (d ) (., d ) = u 0 (c ) (39)
Vy (d ) ., d̂ = 0, d̂ 6= d (40)

Euler equation
u 0 (c ) q d 0 jd = β Pr d 0 jd u 0 c 0 (41)
In more standard form:

βu 0 (c 0 ) 1
1 = Pr d 0 jd (42)
u (c ) q (d 0 jd )
0
where the rate of return on the state contingent claim is 1/q.

Reading
Romer, Advanced Macroeconomics, ch. 7.5

Ljunqvist & Sargent, ch. 7.
Mehra, Rajnish; Edward C. Prescott (1985). "The Equity Premium:
A Puzzle." Journal of Monetary Economics 15(2): 145-61.
Mehra, Rajnish; Edward C. Prescott (2003). "The equity premium in
retrospect." NBER working paper #9525.
Kocherlakota, Narayana R. (1996). "The Equity Premium: It’s Still a
Puzzle." Journal of Economic Literature 34(March): 42-71.

Asset Pricing: Prof. Lutz Hendricks

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Asset pricing

Prof. Lutz Hendricks

November 17, 2010

L. Hendricks () Asset pricing November 17, 2010 1 / 49

1 What determines the rates of return / prices of various assets?

We use the Lucas fruit tree model.

L. Hendricks () Asset pricing November 17, 2010 2 / 49

We study the model introduced by Lucas (1978).

E0 is the expectation as of time t = 0.

L. Hendricks () Asset pricing November 17, 2010 3 / 49

This is an endowment economy.

L. Hendricks () Asset pricing November 17, 2010 4 / 49

The aggregate resource constraint:

Assume that d is a …nite Markov chain with transition matrix

L. Hendricks () Asset pricing November 17, 2010 5 / 49

There are markets for fruits and for trees.

L. Hendricks () Asset pricing November 17, 2010 6 / 49

L. Hendricks () Asset pricing November 17, 2010 7 / 49

V (k, b, d ) = max u (c ) + βEV k 0 , b 0 , d 0 (4)

L. Hendricks () Asset pricing November 17, 2010 8 / 49

L. Hendricks () Asset pricing November 17, 2010 9 / 49

L. Hendricks () Asset pricing November 17, 2010 10 / 49

A solution consists of state contingent plans fc (d t ) , k (d t ) , b (d t )g

L. Hendricks () Asset pricing November 17, 2010 11 / 49

For every history we need:

There is no trade in equilibrium!

L. Hendricks () Asset pricing November 17, 2010 12 / 49

L. Hendricks () Asset pricing November 17, 2010 13 / 49

L. Hendricks () Asset pricing November 17, 2010 14 / 49

De…ne: Marginal rate of substitution:

MRSt +1 is inversely related to consumption growth.

With constant R, the household chooses constant consumption

With high σ, marginal utility changes a lot when c changes.

L. Hendricks () Asset pricing November 17, 2010 17 / 49

We will now derive the famous Lucas asset pricing equation.

L. Hendricks () Asset pricing November 17, 2010 18 / 49

Re-write asset pricing equation using

1 = E fMRS g E fR g + Cov (MRS, R )

L. Hendricks () Asset pricing November 17, 2010 19 / 49

High returns require low Cov (MRS, R ).

L. Hendricks () Asset pricing November 17, 2010 20 / 49

L. Hendricks () Asset pricing November 17, 2010 21 / 49

A "risky" asset has expected return

The risk premium is

This de…nes what risk means: covariance with consumption

L. Hendricks () Asset pricing November 17, 2010 23 / 49

L. Hendricks () Asset pricing November 17, 2010 24 / 49

A back-of-the envelope calculation with CRRA utility:

Cov β [ct +1 /ct ] σ , Rs

Take log utility: σ = 1.

L. Hendricks () Asset pricing November 17, 2010 25 / 49

Investors forego very large returns.

Mehra & Prescott (2003)

L. Hendricks () Asset pricing November 17, 2010 26 / 49

Over 20 year holding periods: stocks dominate bonds.

Mehra & Prescott (2003)

L. Hendricks () Asset pricing November 17, 2010 27 / 49

The EP puzzle shows that we do not understand

L. Hendricks () Asset pricing November 17, 2010 28 / 49

Proposed explanations include:

L. Hendricks () Asset pricing November 17, 2010 29 / 49

Now we derive the famous "beta" measure of risk.