Asset pricing.

Campbell, John Y.

The NBER established its Program in Asset Pricing in the fall of 1991. This program, together with those in monetary economics and corporate finance, grew out of the earlier financial markets and monetary economics program, and has close links with the Program in International Finance and Macroeconomics. Asset pricing is the study of markets for financial assets, including stocks, bonds, foreign currencies, and derivative securities, such as futures and options. It is a highly technical field of economics, but also one in which new ideas are applied rapidly by practitioners, who take a keen interest in academic research. NBER economists have been studying a variety of topics within the field, including general equilibrium asset pricing models, international financial integration, derivative securities, and some intriguing microeconomic puzzles about asset price behavior.

Asset Pricing in General Equilibrium

One fundamental insight of modem financial theory is that a "stochastic discount factor" exists that can be used to calculate the expected return and price of any asset, given information about the pattern of its cash flows. Without this factor, investors could make riskless profits through arbitrage operations. Different asset pricing models imply different stochastic discount factors, and some models include many stochastic discount factors that will price the assets that are traded. But any model that rules out arbitrage opportunities has at least one stochastic discount factor.

Several NBER economists have been trying to characterize the stochastic discount factor that prices the assets traded in today's world economy. John H. Cochrane and Lars P. Hansen have provided a useful general overview, showing that the stochastic discount factor must be highly volatile if it is to price U.S. equities and fixed-income securities.(1) This poses a problem, because the standard macroeconomic asset pricing model, which aggregates investors into a single "representative agent" who consumes aggregate consumption, implies that the stochastic discount factor is not very volatile when the representative agent has standard preferences and attitudes toward risk.

One response to this problem is to explore different models of investors' preferences. Phillip A. Braun, George M. Constantinides, and Wayne E. Ferson have argued that past consumption may increase the marginal utility of today's consumption; this "habit-formation" effect greatly increases investors' risk aversion whenever consumption is close to the habit level determined by the recent past history of consumption.(2) Geert Bekaert, Robert J. Hodrick, and David A. Marshall have explored a model of "first-order risk aversion" in which investors are more concerned about small risks than they are in the standard model.(3) Shlomo Benartzi and Richard H. Thaler have developed a heterodox psychological theory of investor behavior that implies that investors place more weight on the possibility of short-term losses than on the hope of short-term gains.(4)

Other NBER economists have argued that aggregate consumption does not adequately measure the risks borne by the investors who are active in asset markets. Cochrane has suggested that it might be better to relate asset prices to the production side of the economy rather than the consumption side, while I have developed a framework in which one can measure risks without using aggregate consumption data.(5) The framework assumes that markets are complete so that investors can share their risks, but it is also possible that investors are more wary of risky assets because they bear uninsurable idiosyncratic risk. Philippe Weil, and John Heaton and Deborah Lucas have considered the consequences of uninsurable risk for asset pricing.(6)

It is fair to say that no consensus has been reached yet about the right way to model the stochastic discount factor, but work in the NBER asset pricing program and elsewhere is yielding considerable insight into the problem.

International Financial Integration

One of the most important developments of the last few decades has been the integration of financial markets located in different countries. Twenty years ago it was common for financial economists to ignore foreign markets, but this practice is no longer defensible. K. C. Chan, G. Andrew Karolyi, and Rene M. Stulz, for example, have shown that the risk premium on a U.S. stock index is explained poorly by the variance of the stock index return (the traditional domestic measure of risk), but is explained much better by the covariance of the index with foreign stock markets.(7) Bernard Dumas and Bruno Solnik have shown that the risk of exchange rate fluctuations is important in determining the expected returns on foreign currencies and equities.(8)

Kenneth A. Froot has demonstrated that there is a further link between currency fluctuations and stock market movements. In the short run, there is almost no correlation between exchange rate movements and local-currency returns on foreign stocks, but over several years this correlation becomes important. Froot concludes that investor horizons are important in determining the extent to which investors should hedge their foreign equity investments against currency fluctuations.(9)

In an integrated world financial market, it is natural to treat different countries' stock markets as potential investments, to be analyzed in the same way as domestic stock portfolios. In joint work with Ferson, Campbell R. Harvey has explored the characteristics of developed-country stock markets from this perspective.(10) Harvey recently has extended this work to study emerging stock markets.(11)

Derivative Securities

An equally important transformation in the world of finance has been the growth of markets for options and other derivative securities. Because options prices are influenced importantly by the volatility of underlying security prices, options markets offer economists the opportunity to measure market expectations of future volatility. Several NBER economists have shown that implied volatilities from options markets are not optimal forecasts of future realized volatilities. Shang-Jin Wei and Jeffrey A. Frankel have argued that implied volatilities tend to vary more than rational forecasts of future volatility.(12) Jaesun Noh, Robert F. Engle, and Alex Kane have shown that one can earn profits in options markets by trading on differences between option-implied volatilities and forecast volatilities from an econometric model.(13)

Robert J. Shiller has argued that the development of new derivatives markets offers important benefits to society. In several papers and a forthcoming book, he advocates the establishment of futures markets for trading macroeconomic risks including the risks of fluctuations in house prices and components of national income.(14)

Some Puzzles

Scientific advances often result from efforts to resolve puzzling discrepancies between observed reality and the predictions of standard theories. Asset pricing program members have illustrated this in several interesting papers. Zvi Bodie, Robert C. Merton, and William F. Samuelson have asked why investment advisers commonly recommend that older people should be more cautious in their investments than younger people. This advice conflicts with the standard theory, which ignores the fact that younger people can absorb risks by varying their labor supply (for example, by retiring later if their investments do poorly). Bodie, Merton, and Samuelson show that conventional investment advice can be justified if the standard theory is augmented to allow for labor supply flexibility.(15)

Jeremy C. Stein has asked why trading activity in the housing market tends to be more intense in rising markets than in falling markets. He points out that the significant downpayments needed to buy houses make buyer liquidity an important determinant of demand. He develops a model in which falling house prices reduce the ability of homeowners to make downpayments on new homes; this reduces transactions volume in housing markets.(16)

David H. Romer has asked why asset prices sometimes change dramatically in the apparent absence of any important news. He suggests that trading itself may be a source of news. He constructs a model in which each investor thinks that other investors may have good news that can justify a high price. A small downward move in the asset price then may disabuse each investor and lead to a large price decline. Romer offers this as a stylized explanation for the October 1987 market break and other similar episodes.(17)

Other Activities

This report has emphasized the basic research being done by members of the asset pricing program. The NBER also seeks to identify intellectually challenging questions of practical importance and to encourage work that will answer them. Members of the asset pricing program have taken part in two meetings with these objectives: a February 1993 roundtable discussion with regulators and practitioners on the regulation of derivative securities, and a January 1994 conference, organized by Andrew W. Lo and sponsored jointly by the NBER and the New York Stock Exchange, on "The Industrial Organization of the Securities Industry." There is no shortage of relevant questions in asset pricing, and the asset pricing program will continue to sponsor meetings and research to address them.

1 J. H. Cochrane and L. P. Hansen, "Asset Pricing Explorations for Macroeconomics," in NBER Macroeconomics Annual 1992, O.J. Blanchard and S. Fischer, eds. Cambridge: MIT Press, 1992, pp. 115-169. See also S. G. Cecchetti, P. Lam, and N. Mark, "Testing Volatility Restrictions on Intertemporal Marginal Rates of Substitution Implied by Euler Equations and Asset Returns, "forthcoming in Journal of Finance.

2 P. A. Braun, G. M. Constantinides, and W. E. Ferson, "Time Nonseparability in Aggregate Consumption: International Evidence," NBER Working Paper No. 4104, June 1992.

3 G. Bekaert, R. J. Hodrick, and D. A. Marshall, "The Implications of First-Order Risk Aversion for Asset Market Risk Premiums," NBER Working Paper No. 4624, January 1994.

4 S. Benartzi and R. H. Thaler, "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Paper No. 4369, May 1993.

5 J. H. Cochrane, "A Cross-Sectional Test of a Production-Based Asset Pricing Model, "NBER Working Paper No. 4025, March 1992; J. Y. Campbell, "Intertemporal Asset Pricing Without Consumption Data," American Economic Review 83 (June 1993), pp. 487-512, and "Understanding Risk and Return," NBER Working Paper No. 4554, November 1993.

6 P. Weil, "Equilibrium Asset Prices with Undiversifiable Labor Income Risk," NBER Working Paper No. 3975, January 1992; J. Heaton and D. Lucas, "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Paper No. 4249, January 1993.

7 K. C. Chan, G. A. Karolyi, and R. M. Stulz, "Global Financial Markets and the Risk Premium on U.S. Equity," NBER Working Paper No. 4074, May 1992.

8 B. Dumas and B. Solnik, 'The World Price of Foreign Exchange Risk," NBER Working Paper No. 4459, September 1993. A useful review of this topic is R. M. Stulz, "International Portfolio Choice and Asset Pricing: An Integrative Survey," NBER Working Paper No. 4645, February 1994.

9 K. A. Froot, "Currency Hedging Over Long Horizons," NBER Working Paper No. 4355, May 1993.

10 W. E. Ferson and C. R. Harvey, "An Exploratory Investigation of the Fundamental Determinants of National Equity Market Returns," NBER Working Paper No. 4595, December 1993, and "Sources of Risk and Expected Returns in Global Equity Markets," NBER Working Paper No. 4622, January 1994.

11 C. R. Harvey, "Predictable Risk and Returns in Emerging Markets," NBER Working Paper No. 4621, January 1994, and "Conditional Asset Allocation in Emerging Markets," NBER Working Paper No. 4623, January 1994.

12 S.-J. wei and J. A. Frankel, "Are Option-Implied Forecasts of Exchange Rate Volatility Excessively Variable?" NBER Working Paper No. 3910, November 1991.

13 J. Noh, R. F. Engle, and A. Kane, "A Test of Efficiency for the S&P 500 Index Option Market Using Variance Forecasts," NBER Working Paper No. 4520, November 1993. See also D. S. Bates, "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in PHLX Deutschemark Options," NBER Working Paper No. 4596, December 1993.

14 R. J. Shiller, "Measuring Asset Values for Cash Settlement in Derivative Markets: Hedonic Repeated Measures Indices and Perpetual Futures," Journal of Finance 48 (July 1993), pp. 911-931, "Aggregate Income Risks and Hedging Mechanisms, "NBER Working Paper No. 4396, July 1993, and in Macro Markets: Creating Institutions for Managing Society's Largest Economic Risks, Oxford: Oxford University Press, 1994.

15 Z. Bodie, W. F. Samuelson, and R. C. Merton, "Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model," NBER Working Paper No. 3954, January 1992.

16 J. C. Stein, "Prices and Trading Volume in the Housing Market: A Model with Downpayment Effects," NBER Working Paper No. 4373, May 1993.

17 D. H. Romer, "Rational Asset-Price Movements Without News," American Economic Review 83 (December 1993), pp. 1112-1130.