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Ch. 1.

Introduction Asset Pricing (721383S)


Juha Joenvr
University of Oulu
March 2014

Abstract
The rst chapter aims to introduce the main concepts of asset pricing theory based on the stochastic
discount factor approach. The main idea is that asset prices should equal to their expected discounted
value. The chapter motivates the use of the stochastic discount factor approach by presenting the
main empirical facts of return predictability over time and across asset classes.
After this chapter, the students should have a basic understanding why market e ciency is not
anymore the most important part of asset pricing. Instead of testing market e ciency testing students
should try to understand using stochastic discount factor approach why discount rates vary over time
and across assets.

1
1 Introduction to asset pricing

Asset pricing theory tries to understand the prices and values of claims
to uncertain payments (cashows):

A low price implies a high rate of return - hence, we can also think of
the theory as explaining why some assets pay higher average returns
than others.

To value an asset, we have to account for the delay and for the risk of
its payment: the eects of time are easy to work out, but uncertainty or
corrections for risk make asset pricing interesting and challenging.

The eects of timing are easier to work out than those of risk.

Asset pricing theory shares the positive vs. normative tension present in
the rest of economics:

Does it describe the way the world does work (positive), or the way
the world should work (normative)?
If the world does not obey a models predictions, we can decide that
the model needs improvement.
We can also decide that the world is wrong, that some assets are
mispricedand present trading opportunities.

2
1.1 Absolute and Relative Pricing
There are two popular approaches to this elaboration: absolute and rel-
ative pricing.
In absolute pricing, we price each asset by reference to its exposure to
fundamental sources of macroeconomic risk:

Starts from rst fundamentals, such as endowment process and risk


aversion.
The consumption-based (CCAPM) and general equilibrium models.

In relative pricing the question is less ambitious:

We ask what we can learn about an assets value given the prices of
some other assets.
We do not ask where the prices of other assets come from, and we use
as little information about fundamental risk factors as possible.
Relative pricing takes prices of some asset set as given and prices a
second asset set relative to the rst.
Black-Scholes-Merton option pricing model.

3
1.2 Two Central Concepts in Asset Pricing
1. No arbitrage principle.

Market forces tend to align prices so as to eliminate arbitrage oppor-


tunities.
An arbitrage opportunity arises when assets can be combined in a
portfolio with zero cost, no change of a loss and positive probability
of a gain.

2. Financial market equilibrium.

Investorsdesired holdings of nancial assets derive from an optimiza-


tion problem (Consumption-investment problem)
In equilibrium, the rst-order conditions of the optimization problem
must be satised, and asset pricing models follow from those condi-
tions.
In fact, using rst-order conditions can be obtained marginal rate of
substitution, which turn out to be equal to the discount factor

When the agent considers the consequences of the investment decision


for more than a single period in the future, intertemporal asset pricing
models result.

4
1.3 Milestones of Asset Pricing
1. Asset Pricing Theory

1. Portfolio theory (Markowitz 1952; Roy 1952)


2. Mean-variance frontier (Tobin 1958; Markowitz 1959)
3. CAPM (Sharpe 1964; Lintner 1965; Mossin 1966; Treynor 1999/1962)
4. APT (Ross 1976) and multi-beta pricing models.
5. Option pricing ( Black & Scholes 1973, Merton 1973)
6. Contingent claims state preferences (Arrow 1951, 1953; Debreu 1951)
7. Consumption-based model (Breeden 1979; Rubinstein 1976; Lucas 1978)
8. Stochastic discount factor (SDF) approach;
Cochrane (2005) shows that All the theories are special cases of SDF
approach

B. Empirical Asset Pricing

1. Chaos!
2. CAPM way quite successful until 1980
3. Size and value anomalies
4. Fama and French (1993, 1996) model explained size and value anomalies
quite well.
5. Fama and French (1993, 1996) cannot explain momentum
6. The zoo of variables are related to anomalous returns
7. Chaos Again! We need to try to understand these anomalies!

5
1.4 Facts about return predictability and cross-sectional varia-
tion
Old Fact 1: The CAPM is a good measure of risk and thus a good explana-
tion of the fact that some assets (stocks, portfolios, strategies, or mutual
funds) earn higher average returns than others. The CAPM states that
assets can only earn a high average return if they have a high beta,
which measures the tendency of the individual asset to move up or down
with the market as a whole.
Old Fact 2: Returns are unpredictable, like a coin ip. This is the random
walk theory of stock prices. Though there are bull and bear markets;
long sequences of good and bad past returns; the expected future return
is always about the same. Technical analysis that tries to divine future
returns from patterns of past returns and prices is nearly useless. Bond
returns are not predictable. This is the expectations model of the term
structure. Foreign exchange bets are not predictable. Stock, bond and
foreign exchange market volatility is constant.
Old Fact 3: Professional managers do not reliably outperform simple in-
dexes and passive portfolios once one corrects for risk (beta). While
some do better than the market in any given year, some do worse, and
the outcomes look very much like luck.

6
1.5 New Facts
New Fact 1: There are assets whose average returns can not be explained
by their beta. Multifactor extensions of the CAPM dominate the de-
scription, performance attribution, and explanation of average returns.
Multifactor models associate high average returns with a tendency to
move with other risk factors in addition to movements in the market as
a whole. There are still anomalies that cannot explained by standard
Fama-French (1993) model.
New Fact 2: Returns are predictable. In particular: Variables including
the dividend/price (d/p) ratio and term premium can predict substantial
amounts of stock return variation. This phenomenon occurs over busi-
ness cycle and longer horizons. Daily, weekly, and monthly stock returns
are still close to unpredictable, and technical systems for predicting such
movements are still close to useless. Bond returns are predictable. For-
eign exchange returns are predictable. Volatility does change through
time. Times of past volatility indicate future volatility.
New Fact 3: Some mutual funds seem to outperform simple indexes, even
after controlling for risk through market betas. Fund returns are also
slightly predictable: Past winning funds seem to do better than average
in the future, and past losing funds seem to do worse than average in
the future. For a while, this seemed to indicate that there is some per-
sistent skill in active management. However, multifactor models explain
most fund persistence: Funds earn persistent returns by following fairly
mechanical styles, not by persistent skill at stock selection.

7
Fama (1970 and 1991)

Together, these views reect a guiding principle that as-


set markets are, to a good approximation, informationally
e cient.
Market prices already contain most information about fundamental
value.
The business of discovering information about the value of traded
assets is extremely competitive.
There are no easy quick prots to be made, just as there are not in
any other well-established and competitive industry.
The only way to earn large returns is by taking on additional risk.
However, this seems not anymore supported by the empirical evi-
dence.

Cochrane (2011)
1. We thought 100% of the variation in the market dividend yields was
due to variation in expected cashows; now we know that 100% is
due to variation in discount rates.
2. We thought 100% of the cross-sectional variation in expected returns
came from CAPM, now we think thats about zero and a zoo of new
factors describes the cross section.

8
1.6 Fact 1 (Cross-sectional return variation)

Single-factor CAPM betas cannot explain why some trading strategy


deliver high average returns.
CAPM
E Ri Rf = etai E (Rm) Rf
cov(Ri; Rm)
etai =
var(Rm)

general principle: risk premium = quantity of risk price of risk.


E (Rm) Rf is the market price of risk.

In the absence of alpha, expected return dierentials across assets is


triggered by factor loadings only.
The presence of asset mispricing could give rise to additional cross sec-
tional dierences in expected returns.
Empirical evidence shows that

1. is there (e.g. Fama and French (1993, 1996)


2. varies cross sectionally with rm level variables (e.g. Fama and
French (2008))
3. varies over time with both business conditions and rm level vari-
ables (e.g. Ferson and Harvey (1999))

9
Fama and French (1996) show using portfolio sorts
significant cross-sectional difference across equities

Small vs. large


equities
Value vs. glamour
equities
Fama and French (1993) three factor model explains quite well
the return variation of 25 portfolio based on BE/ME quintiles
Fama and French Three-Factor Model can not explain Momentum,
but it can explain Long-Term Reversals that are related Value.

Add Momentum Factor to Fama and French Model!


Next page you will see that it is not enough!
Pastor and Stambaugh (2003: Even Four-Factor Model can not explain Liquidity Beta
sorted portfolios: Add Liquidity Factor to Asset Pricing Model. Use Five-Factor Model!

Liquidity has become more important recently. Results in Panel C are more significant.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
Fersen and Harvey (1999) show that the alpha varies across time
based on macroeconomic variables such term and default spread
1336 The Journal of Finance

Table IV
Time-Varying Alphas in a Three-Factor Model
The first column shows the average annualized intercept (monthly figure x 12, in percent) in a
regression of the portfolio excess return on a constant and three-factor portfolios. The second
column presents the right-tailed p-value of a heteroskedasticity consistent test of whether this
intercept is equal to zero. The third column reports the p-value of an F-test of whether the
intercept is constant in a model with constant betas. The fourth column reports p-values of an
F-test of the hypothesis that the intercept is constant in the model with time-varying betas. The
alternative for the constant alpha tests is to model the alphas as linear functions of the lagged
instrumental variables. The three-factor portfolios are the market return, a small minus large
firm portfolio, and a high minus low book/market portfolio. The lagged instrumental variables
are described in Table II. The sample is July 1963 to December 1994 and the number of ob-
servations is 378. Returns on 25 value-weighted portfolios formed on size and the ratio of book
value to market value are measured in excess of the return on a 30-day Treasury bill. S1 refers
to the lowest 20 percent of market capitalization, S5 is the largest 20 percent, B1 refers to the
lowest 20 percent of the book/market ratios, and B5 is the highest 20 percent. Bonferroni is the
upper bound on the p-value of a joint test across the portfolios. #<0.05 is the number ofp-values
less than 0.05.

Annual Intercept Test Zero Test Constant Test Constant


(Constant alpha, Unconditional Alpha Alpha
Portfolio constant betas) Alpha (Constant betas) (Time-varying betas)
S1/B1 -6.036 0.000 0.000 0.000
S1/B2 -1.924 0.036 0.002 0.002
S1/B3 -0.880 0.237 0.000 0.000
S1/B4 0.585 0.425 0.000 0.000
S1/B5 0.170 0.815 0.000 0.000
S2/B1 -0.917 0.320 0.002 0.002
S2/B2 -0.465 0.551 0.000 0.001
S2/B3 0.893 0.274 0.001 0.001
S2/B4 0.723 0.303 0.042 0.050
S2/B5 0.034 0.966 0.000 0.000
S3/B1 -1.100 0.239 0.000 0.000
S3/B2 0.100 0.908 0.002 0.003
S3/B3 -0.347 0.683 0.002 0.003
S3/B4 0.672 0.408 0.003 0.004
S3/B5 0.960 0.294 0.001 0.001
S4/B1 1.324 0.154 0.004 0.005
S4/B2 -2.322 0.011 0.000 0.000
S4/B3 -0.963 0.310 0.000 0.000
S4/B4 -0.040 0.969 0.000 0.000
S4/B5 0.476 0.693 0.015 0.019
S5/B1 2.295 0.002 0.000 0.000
S5/B2 -0.683 0.413 0.000 0.000
S5/B3 -1.240 0.222 0.000 0.000
S5/B4 -1.457 0.102 0.002 0.003
S5/B5 -1.678 0.196 0.079 0.092
Bonferroni -0.000 0.000 0.000
# < 0.05 -4 24 24
Denitions of the rm characteristics (Fama and French (2008))

The data are from the Center for Research in Security Prices (CRSP) and Compustat. We measure most of the variables

used to forecast returns once a year. Thus, we use information available in June of year t to forecast the returns in July

of t to June of t+1. The exception is the momentum variable, which we measure every month. Time t for the Compustat

variables in the descriptions below is the scal year end in calendar year t. The forecasting (anomaly) variables are:

MC: Market cap, the natural log of price times shares outstanding at the end of June of year t, from CRSP.

B/M: Book-to-market equity, the natural log of the ratio of the book value of equity to the market value of equity. Book

equity is total assets (Compustat data item 6) for year t-1, minus liabilities (181), plus balance sheet deferred taxes and

investment tax credit (35) if available, minus preferred stock liquidating value (10) if available, or redemption value (56) if

available, or carrying value (130). Market equity is price times shares outstanding at the end of December of t-1, from CRSP.

NS: Net stock issues, the natural log of the ratio of the split-adjusted shares outstanding at the scal year end in t-

1 divided by the split-adjusted shares outstanding at the scal year end in t-2. The split-adjusted shares outstanding is

Compustat shares outstanding (25) times the Compustat adjustment factor (27).

Ac/B: Accruals, the change in operating working capital per split-adjusted share from t-2 to t-1 divided by book equity

per split-adjusted share at t-1. Operating working capital is current assets (4) minus cash and short-term investments (1)

minus current liabilities (5) plus debt in current liabilities (34). We use operating working capital per split-adjusted share to

adjust for the eect of changes in the scale of the rm caused by share issuances and repurchases.

Mom: Momentum, the cumulated continuously compounded stock return from month j-12 to month j-2, where j is the

month of the forecasted return. We measure the momentum variable monthly.

dA/A: Growth in assets, the natural log of the ratio of assets per split-adjusted share at the scal year end in t-1 divided

by assets per split-adjusted share at the scal year end in t-2. This is equivalent to the natural log of the ratio of gross assets

at t-1 (6) divided by gross assets at t-2 minus net stock issues from t-2 to t-1.

Y/B: Protability, equity income (income before extraordinary (18), minus dividends on preferred (19), if available, plus

income statement deferred taxes (50), if available) in t-1 divided by book equity for t-1.

10
Cross-sectional regression in Fama and French (2009), show that
average stock returns vary significantly across firm characteristics
1668 The Journal of Finance

Table IV
Average Slopes and t-statistics from Monthly Cross-Section
Regressions, July 1963December 2005
The table shows average slopes and their t-statistics from monthly cross-section regressions to
predict stock returns. The variables used to predict returns for July of t to June of t+1 are: MC, the
natural log of market cap in June of t (in millions); B/M, the natural log of the ratio of book equity for
the last fiscal year-end in t1 divided by market equity in December of t1; NS (net stock issues),
the change in the natural log of split-adjusted shares outstanding from the fiscal year-end in t2
to t1; Ac/B (accruals), the change in operating working capital per split-adjusted share from t2
to t1 divided by book equity per split-adjusted share in t1; Mom (momentum) for month j, the
cumulative return from month j12 to j2; dA/A (growth in assets), the change in the natural log of
assets per split-adjusted share from t2 to t1; and Y/B (profitability), equity income in t1 divided
by book equity in t1. Zero NS is one if NS is zero and zero otherwise. Neg Y is one if equity income
is negative (zero otherwise). Pos Y/B is Y/B for profitable firms and zero otherwise. Similarly,
Neg Ac/B and Pos Ac/B are Ac/B for firms with negative and positive accruals, respectively.
Each regression includes all the anomaly variables. Int is the average regression intercept and the
average regression R2 is adjusted for degrees of freedom. The t-statistics for the average regression
slopes (or for the differences between the average slopes) use the time-series standard deviations
of the monthly slopes (or the differences between the monthly slopes).

Zero Neg Pos Pos


Int MC B/M Mom NS NS Ac/B Ac/B dA/A Neg Y Y/B R2

Market
Average 1.81 0.18 0.26 0.50 0.11 1.90 0.03 0.34 0.81 0.06 0.92 0.04
t-statistic 5.36 4.36 3.77 3.24 2.41 8.59 0.20 2.72 7.37 0.55 3.19
Micro
Average 2.63 0.46 0.23 0.41 0.16 1.94 0.00 0.28 0.83 0.01 0.55 0.03
t-statistic 7.41 6.95 3.19 2.51 2.83 6.74 0.03 2.02 6.82 0.11 1.50
Small
Average 1.01 0.03 0.30 0.82 0.04 1.49 0.09 0.45 0.57 0.01 1.19 0.05
t-statistic 2.02 0.37 3.41 4.65 0.55 4.42 0.28 2.24 3.10 0.03 2.36
Big
Average 1.06 0.08 0.17 0.78 0.12 1.71 0.12 0.38 0.17 0.11 0.75 0.08
t-statistic 2.61 1.96 1.79 3.92 1.59 5.28 0.32 1.49 0.86 0.46 1.56
All but Micro
Average 1.12 0.08 0.23 0.81 0.09 1.65 0.05 0.49 0.43 0.02 0.93 0.06
t-statistic 2.87 1.92 2.73 4.60 1.41 6.28 0.19 2.87 2.80 0.12 2.35
Micro Small
Difference 1.62 0.43 0.07 0.41 0.11 0.45 0.09 0.17 0.26 0.02 0.64
t-statistic 4.02 5.11 0.93 3.64 1.23 1.12 0.29 0.79 1.35 0.09 1.13
Micro Big
Difference 1.57 0.38 0.06 0.38 0.03 0.23 0.11 0.10 0.66 0.12 0.20
t-statistic 4.02 4.99 0.61 2.42 0.34 0.57 0.29 0.38 2.97 0.52 0.33
Micro All but Micro
Difference 1.51 0.38 0.00 0.40 0.07 0.29 0.05 0.21 0.40 0.03 0.38
t-statistic 4.44 5.28 0.00 3.41 0.88 0.83 0.19 1.14 2.35 0.20 0.76
Small Big
Difference 0.05 0.05 0.12 0.04 0.08 0.22 0.20 0.06 0.39 0.11 0.44
t-statistic 0.12 0.71 1.72 0.31 0.84 0.55 0.48 0.23 1.72 0.36 0.78
1.7 Fact 2 (Return predictability)
Regression of returns (Rt) on lagged returns (Rt 1) :
Rt = a + b Rt 1+"t:

Annual data 1927 today:


b t(b) R2
Stock 0.03 0.28 0.00
T-bill 0.91 19.8 0.83
Excess 0.04 0.33 0.00
Dividend/price ratios forecast excess returns on stock
Dt
Rt+1= a + b +"t+1:
Pt

Regression coe cients and R2 rise with the forecast horizon. This is a
result of the fact that the forecasting variable is persistent.
b t(b) R2
1 year horizon 3.75 2.47 0.07
5 years, overlap 19.7 4.64 0.23
5 years, no overlap 21.1 2.24 0.26
We nd similar evidence across asset classes such as bonds and currencies
and even for shorter horizons like one month.
There are also other macroeconomic variables such as term and default
spread that helps to predict stock and bond returns

11
Fact 3 (mutual fund managers skill (alpha))
Empirical evidence suggests that historically it has been di cult to nd
funds that consistently beat the market on a risk adjusted basis.
Specically, recent evidence (e.g., Fama and French (2010) and Barras,
Scaillet, and Wermers (2009) suggests that mutual funds do not deliver
consistently signicant alpha
However, some hedge funds seem to outperform the market. Kosowski,
Naik and Teo (2007) provide clear evidence that some of the hedge funds
deliver superior performance that persists.
One potential explanation is that the lucrative compensation contracts
and the exibility arising from share restrictions to employ innovative
active portfolio management strategies imply that hedge fund industry
should attract the most skilled fund managers
However, it is not a trivial task to identify and forecast the hedge funds
alpha.
Specically, a large cross-section of hedge funds suggest that some of the
top hedge funds outperform solely due to luck, not skill.
In addition, the nature of hedge fund strategies implies that it is ex-
tremely di cult to model and estimate the joint distribution of hedge
fund and benchmark returns.1
This implies that hedge fund performance or alpha is often measured and
predicted imprecisely with a large estimation error.
1
The problems arise from the fact that it is di cult to identify common risk factors. In addition, typical hedge return
time-series are short with non-linearities and autocorrelation.

12
Table V
Percentiles of Four-factor t() for Actual and Simulated Fund Returns: 1975 to 2002
The table shows values of four-factor t() at selected percentiles (Pct) of the distribution of t() for actual (Act) net
and gross fund returns for funds selected using the exclusion rules of Kosowski et al. (2006) and for funds in our $5
million AUM group selected using our exclusion rules. The period is 1975 to 2002 (as in Kosowski et al. (2006)).
The table also shows the fraction (%<Act) of the 10,000 simulation runs that produce lower values of t() at the
selected percentiles than those observed for actual fund returns. Sim is the average value of t() at the selected
percentiles from the simulations.

Kosowski et al. Exclusion Rules Our Exclusion Rules


Pct Sim Act %<Act Sim Act %<Act
1 -2.48 -3.69 0.18 -2.46 -3.70 0.16
2 -2.16 -3.25 0.19 -2.14 -3.17 0.30
3 -1.96 -2.87 0.53 -1.95 -2.80 0.70
4 -1.82 -2.55 1.34 -1.80 -2.63 0.69
5 -1.70 -2.36 1.90 -1.69 -2.41 1.36
10 -1.31 -1.92 2.17 -1.30 -1.95 1.66
20 -0.85 -1.41 2.15 -0.85 -1.41 2.17
30 -0.52 -1.01 3.18 -0.52 -1.00 3.54
40 -0.25 -0.65 5.75 -0.24 -0.66 5.35
50 0.01 -0.33 9.19 0.01 -0.34 8.50
60 0.27 -0.02 12.20 0.27 -0.03 11.92
70 0.55 0.29 16.51 0.55 0.27 14.86
80 0.87 0.73 32.80 0.87 0.69 28.11
90 1.32 1.44 68.19 1.32 1.34 56.29
95 1.69 1.97 82.42 1.69 1.81 68.32
96 1.80 2.18 88.38 1.80 2.00 75.70
97 1.94 2.38 90.73 1.94 2.25 83.74
98 2.12 2.59 91.38 2.12 2.51 87.57
99 2.40 3.07 95.79 2.42 2.83 88.37

Fama and French (2010) simulations show that only a tiny fraction of active
mutual fund managers beat the marker on a risk adjusted basis.
Sim shows the fund return random variation i.e., the return that can be obtained
solely due to luck.
Act shows actual fund returns, which are not significantly higher that those
which are obtained solely due to luck.

39
Fama and French (2010) shows that mutual funds
actual risk-adjusted returns are generally lower that
100
their random counterparts, which are obtained by
randomly.
90

80

70

60

50

40
Actual
30
Simulated
20

10

0
< -4 < -3 < -2 < -1 < 0 < 1 < 2 < 3 < 4

Figure 1. Simulated and actual cumulative density function of three-factor t() for net
returns, 1984-2006.
41
Kosowski, Naik and Teo (2007) show that hedge funds average alpha is higher that
simulated random alpha. This suggest that hedge funds are capable to beat their
benchmarks even a risk adjusted basis.

0.35
density of actual alpha t-statistics
density of bootstrapped alpha t-statistics
0.3

0.25

0.2

0.15

0.1

0.05

0
-10 -5 0 5 10 15 20 25 30 35 40

Figure 2. Kernel density estimate of the bootstrapped and the actual alpha t -statistic distribution for all funds. The sample period is from January 1994 to December
2002.
1.8 Paradigm shift

The central idea of modern nance is that prices are generated by ex-
pected discounted payos.
Indeed, priced should equal expected discounted cashows

In 1970, Eugene Fama argued that the expected part, testing market
e ciency,provided the framework for organizing asset-pricing research
Cochrane (2011) ague that the discounted part better organizes the
research today, since the evidence show that discount rates vary over
time and across assets.
Based on the theory, we should try to understand why discount rates
vary instead of focusing on Famas weak, semi-wrongand strong
forms of market e ciency
New understanding of discount rate variation has strong inuence on
applications such as portfolio theory, performance evaluation and capital
budgeting.

The fact that returns are predictable suggests that the standard
Markowitz solution relying assumption that returns are iid is not
valid anymore.
Evaluating fund manager performance, one have to take into account
dierent investment styles instead of relying just a single factor mar-
ket model.

13
1.9 Stochastic discount factor (SDF)

The price pt gives rights to a payo xt+1.


Basic pricing formula:
pt = E (mt+1xt+1)
mt+1 = f (data, parameters) ;
where mt+1 is the stochastic discount factor (SDF).
The notation is quite general and allows us easily to accom-
modate many dierent asset pricing questions: we can cover
stocks, bonds, and options and make clear that there is one
theory for all asset pricing.
For stocks, the one-period payo is the next price plus dividend: xt+1 =
pt+1 + dt+1.

14
1.10 The most important forms of SDF

1. The stochastic discount factor mt+1 based on consumpition-based pricing


equation is the marginal rate of substitution:
u0 (ct+1)
mt+1 = ;
u0 (ct)
where u0 ( ) is the rst derivative of pre-specied utility function, is the
subjective discount factor capturing the impatience of consumer, and c
denotes the level of consumption.

SDF is dened as the Marginal rate of substitution


With power utility
ct+1
mt+1 = :
ct

2. The stochastic discount factor mt+1 based on beta-pricing equation such


CAPM:
m
mt+1 = a + b E [Rt+1 ]:

CAPM, Fama-French (1993) model are special cases of the SDF ap-
proach.

The rst special case is based on macroeconomics, whereas the second


special case is based on nancial economics.

15
1.11 Returns and d/p
We usually divide the payo xt+1 by the price pt to obtain a gross return:
Rt+1 xt+1
pt = 1 + rt+1 :

We can think of a return as a payo that has price equal to one: if we pay
one euro today, the return is how many euros or units or consumption
we get tomorrow.
Thus, returns obey
pt xt+1
= E mt+1 , 1 = E (mt+1Rt+1) :
pt pt
that is by far the most important special case of the basic formula p =
E (mx).
Returns are commonly used in empirical work, since they are typically
stationary (the means, variances and autocovariances are independent of
time) over time: they do not have trends.
Dividing by dividends and creating a payo of the form
pt+1 dt+1
xt+1 = 1+
dt+1 dt
corresponds to a price pt=dt that is a way to look at prices, having sta-
tionary variables in the pricing equation.

16
1.12 Risk-Free Rate
If there is no uncertainty, we can express returns
1 = E (mt+1Rt+1) = E (mt+1) Rf (1)
where Rf is the gross risk-free rate.
The risk-free rate is related to the discount factor by
Rf = 1=E(mt+1): (2)

Since Rf is typically greater than one, the payo xt+1 sells at a dis-
count.

17
1.13 Risk Corrections
Using the denitions of covariance
cov(mt+1; xt+1) = E(mt+1xt+1) E(mt+1)E(xt+1);
we can write the pricing equation pt = E(mt+1xt+1) as
p = E(mt+1)E(xt+1) + cov(mt+1; xt+1):

Substituting the risk-free rate equation (2), we obtain


E(xt+1)
pt = + cov(mt+1; xt+1);
Rf
where

the rst term is the standard discounted present-value formula, giv-


ing the assets price in a risk-neutral world (where consumption is
constant or utility is linear)
the second term is risk adjustment.

Using expected returns, we obtain risk premia or expected return


i
E(Rt+1 ) Rf = Rf cov(mt+1; Rt+1
i
);
that is higher for assets having a large negative covariance with the dis-
count factor.
This is an extremely important result! I hope that you understand the
meaning of this after taking this course!
This helps us to understand why some assets have higher expected returns
than others.

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1.14 Important notations and formulas
Table: Notations
Price pt Payo xt+1
Stock pt pt+1 + dt+1
Return 1 Rt+1
pt pt+1 dt+1
Price-dividend ratio dt dt+1 +1 dt
e a b
Excess return 0 Rt+1 = Rt+1 Rt+1
One-period bond pt 1
Risk-free rate 1 Rf

pt = E (mt+1xt+1)
1 = E (mt+1Rt+1)

E(xt+1)
pt = + cov(mt+1; xt+1)
Rf
i
E(Rt+1 ) Rf = Rf cov(mt+1; Rt+1
i
)
| {z }
Risk Corrections

19
References

Barras, L., O. Scaillet, and R. R. Wermers (2009). False discoveries in mu-


tual fund performance: Measuring luck in estimated alphas. The Journal
of Finance. Forthcoming.
Fama, E. F. and K. R. French (2010). Luck versus skill in the cross section
of mutual fund alpha estimates. The Journal of Finance. Forthcoming.
Fung, W., D. A. Hsieh, N. Y. Naik, and T. Ramadorai (2008). Hedge funds:
Performance, risk and capital formation. The Journal of Finance 63 (4),
17771803.
Jagannathan, R., A. Malakhov, and D. Nokikov (2010). Do hot hands exist
amoung hedge fund managers? An empirical evaluation. The Journal of
Finance 65 (1), 217255.
Kosowski, R., N. Y. Naik, and M. Teo (2007). Do hedge funds deliver
alpha? A Bayesian and bootstrap analysis. Journal of Financial Eco-
nomics 84 (1), 229264.

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