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The Paradox of Asset Pricing : Frontiers of Economic Research - Peter L. Bossaerts

The Paradox of Asset Pricing

Frontiers of Economic Research

Paperback Published: 17th January 2005
ISBN: 9780691123134
Number Of Pages: 192
For Ages: 22+ years old

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Asset pricing theory abounds with elegant mathematical models. The logic is so compelling that the models are widely used in policy, from banking, investments, and corporate finance to government. To what extent, however, can these models predict what actually happens in financial markets? In "The Paradox of Asset Pricing," a leading financial researcher argues forcefully that the empirical record is weak at best. Peter Bossaerts undertakes the most thorough, technically sound investigation in many years into the scientific character of the pricing of financial assets. He probes this conundrum by modeling a decidedly volatile phenomenon that, he says, the world of finance has forgotten in its enthusiasm for the efficient markets hypothesis--speculation.

Bossaerts writes that the existing empirical evidence may be tainted by the assumptions needed to make sense of historical field data or by reanalysis of the same data. To address the first problem, he demonstrates that one central assumption--that markets are efficient processors of information, that risk is a knowable quantity, and so on--can be relaxed substantially while retaining core elements of the existing methodology. The new approach brings novel insights to old data. As for the second problem, he proposes that asset pricing theory be studied through experiments in which subjects trade purposely designed assets for real money. This book will be welcomed by finance scholars and all those math--and statistics-minded readers interested in knowing whether there is science beyond the mathematics of finance.

This book provided the foundation for subsequent journal articles that won two prestigious awards: the "2003 Journal of Financial Markets Best Paper Award" and the "2004 Goldman Sachs Asset Management Best Research Paper" for the "Review of Finance."

Industry Reviews

"An important and timely book, [it] offers a fresh look at what the efficient markets hypothesis really implies. Summarizing forty years of asset pricing tests, it compels researchers to think deeply about what they are doing." - Bernt Arne Odegaard, Norwegian School of Management, Central Bank of Norway; "This book, whose rousing style drew me in immediately, is remarkable in how well it is able honestly to convey the core of modern finance theory and then to go on to criticize it fairly." - Thomas Sargent, Stanford University, Hoover Institution"

Prefacep. ix
Principles of Asset-Pricing Theory, Wherein we review the basics of asset-pricing theory, starting from dynamic programming (pointing out some of the surprising simplifications when applied to portfolio analysis), introducing the notion of equilibrium,and then narrowing everything down to arrive at the Capital Asset-Pricing Model (CAPM). The emphasis is on the features that the CAPM shares with virtually all other asset-pricing models,namely, in equilibrium, prices are set so that expected excess returns are proportional to covariance with aggregate risk
Introductionp. 1
Stochastic Dynamic Programmingp. 2
An Application to a Simple Investment-Consumption Problemp. 8
A Nontrivial Portfolio Problemp. 10
Portfolio Separationp. 11
Toward the First Asset-Pricing Modelp. 15
Consumption-Based Asset-Pricing Modelsp. 17
Asset-Pricing Theory: The Bottom Linep. 21
Arrow-Debreu Securities Pricingp. 22
Roll''s Critiquep. 23
Time Nonseparable Preferencesp. 24
Existence of Equilibriump. 26
Price Discoveryp. 28
Exercisesp. 36
Empirical Methodology, Empirical tests of asset-pricing theory require the researcher to make auxiliary assumptions that are not necessarily an integral part of the theory. Most prominent is the assumption that ties ex-ante beliefs (which determine prices) to the ex-post frequencies of the payoffs, which has become known as the efficient markets hypothesis (EMH). EMH dramatically simplifies empirical methodology. We review three important types of tests that it generated: (1) Tests of the mean-variance efficiency of benchmark portfolio(s); (2)stochastic Euler equation tests; and (3) variance bounds tests
Introductionp. 39
The Efficient Markets Hypothesis (EMH)p. 42
Violations of the Stationarity Assumptionp. 46
Inference in a Nonstationary Worldp. 53
Testing the CAPMp. 55
A Linear Testp. 56
A Nonlinear Testp. 57
The Fama-MacBeth Procedurep. 58
Can One Condition on Less than the Entire State Vector in Tests of the CAPM?p. 59
Testing Consumption-Based Asset-Pricing Modelsp. 63
Diagnostics: Variance Boundsp. 66
Exercisesp. 69
The Empirical Evidence in a Nutshell. An anthology of the extensive literature on tests of asset-pricing models enables us to form a fairly comprehensive image of the empirical evidence. Few would be encouraged by the results
Introductionp. 71
Empirical Evidence on the CAPMp. 72
Hansen-Jagannathan Boundsp. 83
GMM Tests of Consumption-Based Modelsp. 89
Cross-Sectional Testsp. 95
Conclusionp. 100
Exercisesp. 101
The Experimental Evidence. But perhaps we are demanding too much from empirical studies of historical data from field markets. What about the evidence from simple, purposely built experimental markets? Some principles emerge well and alive (e.g., the CAPM), others can be rejected outright (e.g., instantaneous equilibration). The lab also allows us to discover things that are fundamental to economic theory but difficult to detect in historical data, such as the ranking of Arrow-Debreu securities prices. At the same time, we experience how hard it is to control beliefs
Introductionp. 103
A Typical Asset-Pricing Experimentp. 107
Theoretical Predictionsp. 110
Experimental Resultsp. 111
Announced and Perceived Uncertaintyp. 116
The Scale of Experimentationp. 122
Formal Testsp. 124
The CAPMp. 124
The Arrow-Debreu Modelp. 126
Conclusionp. 128
From EMH to Merely Efficient Learning. Although we obviously do not yet understand how to extrapolate lab results to the giant and complex field markets, we can investigate whether our econometric methodology has not been the cause of the empirical failure of asset-pricing theory. The first suspect is EMH. The criticism will be constructive, by demonstrating that EMH is unnecessarily strong: much of the simplicity of the EMH-based empirical methodology can be retained even if one cuts out the most objectionable part. We develop a new methodology for testing asset-pricing models that allows the market to hold mistaken expectations at times, but still requires it to learn as under EMH. We will call it the hypothesis of efficiently learning markets (ELM)
Introductionp. 131
Bayesian Learningp. 137
Digital Option Prices under ELMp. 140
Limited Liability Security Prices under ELMp. 142
Revisiting an Earlier Examplep. 147
Conclusionp. 151
Exercisesp. 152
Revisiting the Historical Record. Armed with new tools, we can revisit historical data. We investigate the aftermarket performance of almost five thousand U.S. initial public offerings (IPOs) in the period 1975-95. Although not perfect, we find far more support for the theory. The example suggests that we may want to substitute ELM for EMH in future studies of historical data from field markets
Introductionp. 153
U.S. IPO Aftermarket Performancep. 154
Conclusionp. 162
Referencesp. 163
Indexp. 169
Table of Contents provided by Publisher. All Rights Reserved.

ISBN: 9780691123134
ISBN-10: 0691123136
Series: Frontiers of Economic Research
Audience: Tertiary; University or College
For Ages: 22+ years old
Format: Paperback
Language: English
Number Of Pages: 192
Published: 17th January 2005
Publisher: Princeton University Press
Country of Publication: US
Dimensions (cm): 21.59 x 13.97  x 1.27
Weight (kg): 0.3