THE DEMAND FOR RISKY ASSETS: Some Extensions
TL;DR: In this paper, the same analytical framework is used to obtain new results on the effect of inflation on the market price of risk, and it turns out that by using nominal values for returns, the market prices of risk under inflation is increased by positive covariance between the rate of inflation and the market rate of return, and decreased by negative covariance.
Abstract: Publisher Summary This chapter discusses some extensions on the demand for risky assets. The research on capital asset pricing has until very recently been devoted almost exclusively to the interrelationships of the risk premiums among different risky assets rather than to the determinants of the market price of risk. Such research has also generally relied on theoretical preconceptions to determine the appropriate utility functions of individual investors upon which both the market price of risk and the pricing of individual risky assets depend. The chapter discusses the highlights of the theoretical and empirical analysis and their conclusions. Then, the same analytical framework is used to obtain new results on the effect of inflation on the market price of risk. It turns out that by using nominal values for returns, the market price of risk under inflation is increased by positive covariance between the rate of inflation and the market rate of return, and decreased by negative covariance. However, statistically as the actual covariance has been very small since the latter part of the 19th century, at least in the USA, the measured market price of risk is not affected appreciably by the adjustment for inflation.
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TL;DR: This paper showed that an equilibrium model which is not an Arrow-Debreu economy will be the one that simultaneously rationalizes both historically observed large average equity return and the small average risk-free return.
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TL;DR: The model financial economics encompasses finance, micro-investment theory and much of the economics of uncertainty as mentioned in this paper, and it has had a direct and significant influence on practice, as is evident from its influence on other branches of economics including public finance, industrial organization and monetary theory.
Abstract: THE SPHERE of model financial economics encompasses finance, micro investment theory and much of the economics of uncertainty. As is evident from its influence on other branches of economics including public finance, industrial organization and monetary theory, the boundaries of this sphere are both permeable and flexible. The complex interactions of time and uncertainty guarantee intellectual challenge and intrinsic excitement to the study of financial economics. Indeed, the mathematics of the subject contain some of the most interesting applications of probability and optimization theory. But for all its mathematical refinement, the research has nevertheless had a direct and significant influence on practice. ’ It was not always thus. Thirty years ago, finance theory was little more than a collection of anecdotes, rules of thumb, and manipulations of accounting data with an almost exclusive focus on corporate financial management. There is no need in this meeting of the guild to recount the subsequent evolution from this conceptual potpourri to a rigorous economic theory subjected to systematic empirical examination? Nor is there a need on this occasion to document the wide-ranging impact of the research on finance practice.2 I simply note that the conjoining of intrinsic intellectual interest with extrinsic application is a prevailing theme of research in financial economics. The later stages of this successful evolution have however been marked by a substantial accumulation of empirical anomalies; discoveries of theoretical inconsistencies; and a well-founded concern about the statistical power of many of the test methodologies.3 Finance thus finds itself today in the seemingly-paradoxical position of having more questions and empirical puzzles than at the start of its
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TL;DR: In this article, the authors examined the relation between stock returns and stock market volatility and found that the expected market risk premium (the expected return on a stock portfolio minus the Treasury bill yield) is positively related to the predictable volatility of stock returns.
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Cites background from "THE DEMAND FOR RISKY ASSETS: Some E..."
...For example, Friend and Blume (1975) estimate relative risk aversion to be about 2.0, Hansen and Singleton (1982) obtain estimates between - 1.6 and 1.6, and Brown and Gibbons (1985) obtain estimates between 0.1 and 7.3....
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TL;DR: In this article, the authors adopt the Keynesian view that direct shocks to investment are important for business fluctuations, but incorporate them in a neo-classical framework where the rate of capital expenditure is fixed.
Abstract: The present paper adopts the Keynesian view that direct shocks to investment are important for business fluctuations, but incorporates them in a neo-classical framework where the rate of capital ut ...
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TL;DR: In this paper, a simple equilibrium model with liquidity risk is proposed, where a security's required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with the market return.
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TL;DR: In this article, an intertemporal model for the capital market is deduced from portfolio selection behavior by an arbitrary number of investors who aot so as to maximize the expected utility of lifetime consumption and who can trade continuously in time.
Abstract: An intertemporal model for the capital market is deduced from the portfolio selection behavior by an arbitrary number of investors who aot so as to maximize the expected utility of lifetime consumption and who can trade continuously in time. Explicit demand functions for assets are derived, and it is shown that, unlike the one-period model, current demands are affected by the possibility of uncertain changes in future investment opportunities. After aggregating demands and requiring market clearing, the equilibrium relationships among expected returns are derived, and contrary to the classical capital asset pricing model, expected returns on risky assets may differ from the riskless rate even when they have no systematic or market risk. ONE OF THE MORE important developments in modern capital market theory is the Sharpe-Lintner-Mossin mean-variance equilibrium model of exchange, commonly called the capital asset pricing model.2 Although the model has been the basis for more than one hundred academic papers and has had significant impact on the non-academic financial community,' it is still subject to theoretical and empirical criticism. Because the model assumes that investors choose their portfolios according to the Markowitz [21] mean-variance criterion, it is subject to all the theoretical objections to this criterion, of which there are many.4 It has also been criticized for the additional assumptions required,5 especially homogeneous expectations and the single-period nature of the model. The proponents of the model who agree with the theoretical objections, but who argue that the capital market operates "as if" these assumptions were satisfied, are themselves not beyond criticism. While the model predicts that the expected excess return from holding an asset is proportional to the covariance of its return with the market
6,294 citations
TL;DR: In this paper, the authors present an alternative way to relate the expected utility and mean-variance approaches, and present proofs of the usefulness of mean and variance in situations involving less and less risk.
Abstract: Publisher Summary The chapter presents an alternative way to relate the expected utility and mean-variance approaches. It presents proofs of the two general theorems involved in an aspect of the mean-variance model—namely, the usefulness of mean and variance in situations involving less and less risk. It describes a defense of mean-variance analysis and highlights its exact limitations along with those for any r-moment model. The mean and variance of wealth are approximately sufficient parameters for the portfolio selection model when the probability distribution of wealth is compact. In the compact case, moments of order 3 and higher are small in magnitude relative to the first two moments of the portfolio return; hence, a limiting approximation indicates that only the first two moments are relevant for optimal portfolio selection.
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TL;DR: In a recent survey of monetary theory, this article showed that monetary theory as a part of capital theory is different from those who view monetary theory only as a problem in balance sheet equilibrium or asset choice.
Abstract: T *IHE arguments or variables that enter the demand function for money, and the definition of the quantity of money appropriate for the demand function, have received substantial attention in both the recent and more distant past. For present purposes, it is useful to distinguish three separate disputes about these variables. First, there is the question of the constraint that is imposed on money balances-whether the appropriate constraint is a measure of wealth, income, or some combination of the two. A second dispute has centered on the importance of interest rates and price changes as arguments in the demand function. Third, the question of the definition of money balances has often been raised. Is a more stable demand function obtained if money is defined inclusive or exclusive of time and/or savings deposits, and perhaps other assets that have value fixed in money terms? In his recent survey of monetary theory, Harry Johnson has suggested that the above issues-the definition of money to be used in the money demand function, the variables on which the demand for money depends, and the stability of 1 This article is a part of the research on monetary theory and monetary policy conducted under the joint responsibility of Karl Brunner, of the University of California, Los Angeles, and myself. I wish to acknowledge many helpful discussions with Brunner. The suggestions made by Philip Cagan, Michael Hamburger, and Richard Nelson and the excellent assistance of George Haines and Peter Frost have contributed to the paper. I would like also to express appreciation for the research support made available by the Graduate School of Industrial Administration, Carnegie Institute of Technology. the demand function-are the chief substantive issues outstanding in monetary theory.2 This paper deals with each of them and attempts to evaluate empirically the results obtained from some alternative money demand functions and some alternative definitions of money. These results are used to appraise some propositions that have been advanced in monetary theory. With respect to one of these issues, the constraint on money balances the wellknown work of Hicks, and the more recent studies of Friedman and Tobin suggest that monetary theorists are now agreed that the demand function for money is to be treated as a problem in balance sheet equilibrium or asset choice.3 However, there are important differences among those who view monetary theory as a part of capital theory. Two of these differences are noted here. One concerns the importance of money for macroeconomic theory; the other is the question of the definition of wealth.
399 citations