IF Summary – Lecture 2
Learning Goals
1. Describe the basic theory behind global asset pricing.
Summarize its key empirical implications.
2. Summarize the evidence on basic global equity pricing model.
Compare the theoretical implications with the accumulated empirical evidence
3. Describe the models which extend the basic model to incorporate local factors.
Differentiate the theoretical explanations advanced in these models.
Evaluate empirical success of these models to describe global equity returns
Motivation: Looking at the very long trends in returns on major asset classes reveals some
interesting regularities and puzzles
- Housing and equity returns are similar (about 7%p.a.), but housing returns are less
volatile
o Puzzling performance of real estate because it is immobile, very hard to
diversify exposure and high transaction costs!
o With globalization, equity returns have become increasingly correlated across
countries over time, but housing returns have remained globally uncorrelated
- Real returns on government debt (safest assets) have been low and volatile
o More volatile than some risky-assets, so apparently not as risk-free as
assumed!
- Market risk premium (MRP) (difference between return on risky asset and safe
assets)
o MRP is 4-5% excluding wartime, but has significant variation at low frequency
(decades)
o What drives the volatility in MRP? The safe assets (which should be flat in
volatility)!!!
▪ Risky assets are more stable around 6-8%
- Return on wealth are higher than growth rates but the gap is unrelated to growth
o Difference is much larger than we anticipated
o It moves very steady, but not with the business cycle/growth rate of the
economy ➔ Cannot be explained by economic fundamentals
Key challenges for global asset pricing
Despite fin. globalization, local country-specific factors continue to affect globally traded
asset prices. Why?
- National monetary policy
o Affects asset prices through currency risk or real exchange rate changes
- Capital markets segmentation
o Due to market frictions
- National fiscal policy
o Affects returns through taxes, expected taxes, or sovereign risk
➔ A good model of global asset pricing needs to be able to explain the following observed
relationships
- Equity returns depend on both domestic and global risk factors
- Home equity bias by local investors
- Co-movement of returns and international capital flows
- Premium around the cross-listing of firms
, In addition to that, it should also consider currencies and international bonds!
Learning Goal 1: Describe the basic theory behind global asset pricing. Summarize its key
empirical implications
Theory of global asset pricing: Assumptions:
- Individuals can invest in many assets with uncertain returns
o Uncertainty is important to describe asset choices by investors
- Market frictions exists, but are not crucial relative to uncertain returns
- Assume perfectly competitive asset markets (for now)
Traditional CAPM
Based on Markovitz’ theory: Investors are only concerned with the mean and variance of
their portfolio return.
o Expected returns are premiums proportional to market betas (covariance of
asset returns with the returns on the “market portfolio).
- Attractive because it captures risk and returns
- But doesn’t relate to more fundamental needs of investors (e.g. consumption)!
- Simplicity: No need for assuming preferences or risk-aversion of investors
Consumption CAPM
Starts from the basic theory of consumption under uncertainty, but unlike consumption
theory (which takes return on assets as given and derives how much to consume), we take
the consumption as given and derive uncertain return on assets!
- Investors are consumers (Need to eat/buy durables as well)
- Focuses on a consumption beta instead of a market beta to explain expected return
premiums over the risk-free rate
o Consumption beta = covariance between assets return & consumption
- Assets are priced explicitly relative to our utility from consumption
Assumptions:
Utility function:
- Utility function (exogenous; Taken as given)
o 2 key features: Investors are risk-averse & prefers a steady consumption
stream over time/across states of nature
o To avoid volatility in consumption, we need to invest!
- Diminishing marginal utility of consumption: More consumption equals more utility
➔ shown by positive FOC (U'(c_t)>0), but at a declining rate, U''(.)<0 (shown by neg.
SOC).
o 1st Order derivative Marginal Utility of Consumption U’(.)>0; increasing shows
utility is non-saturated (More is always better)
o 2nd Order derivative U”(.)<0 because it’s negative, it shows diminishing
returns for the Marginal utility of consumption
General assumptions:
- Investor can save (to smooth consumption over time) by buying one of i=1…n risky
assets with a net stochastic (random) return of zit or by investing in a risk-free asset
with return rt
Learning Goals
1. Describe the basic theory behind global asset pricing.
Summarize its key empirical implications.
2. Summarize the evidence on basic global equity pricing model.
Compare the theoretical implications with the accumulated empirical evidence
3. Describe the models which extend the basic model to incorporate local factors.
Differentiate the theoretical explanations advanced in these models.
Evaluate empirical success of these models to describe global equity returns
Motivation: Looking at the very long trends in returns on major asset classes reveals some
interesting regularities and puzzles
- Housing and equity returns are similar (about 7%p.a.), but housing returns are less
volatile
o Puzzling performance of real estate because it is immobile, very hard to
diversify exposure and high transaction costs!
o With globalization, equity returns have become increasingly correlated across
countries over time, but housing returns have remained globally uncorrelated
- Real returns on government debt (safest assets) have been low and volatile
o More volatile than some risky-assets, so apparently not as risk-free as
assumed!
- Market risk premium (MRP) (difference between return on risky asset and safe
assets)
o MRP is 4-5% excluding wartime, but has significant variation at low frequency
(decades)
o What drives the volatility in MRP? The safe assets (which should be flat in
volatility)!!!
▪ Risky assets are more stable around 6-8%
- Return on wealth are higher than growth rates but the gap is unrelated to growth
o Difference is much larger than we anticipated
o It moves very steady, but not with the business cycle/growth rate of the
economy ➔ Cannot be explained by economic fundamentals
Key challenges for global asset pricing
Despite fin. globalization, local country-specific factors continue to affect globally traded
asset prices. Why?
- National monetary policy
o Affects asset prices through currency risk or real exchange rate changes
- Capital markets segmentation
o Due to market frictions
- National fiscal policy
o Affects returns through taxes, expected taxes, or sovereign risk
➔ A good model of global asset pricing needs to be able to explain the following observed
relationships
- Equity returns depend on both domestic and global risk factors
- Home equity bias by local investors
- Co-movement of returns and international capital flows
- Premium around the cross-listing of firms
, In addition to that, it should also consider currencies and international bonds!
Learning Goal 1: Describe the basic theory behind global asset pricing. Summarize its key
empirical implications
Theory of global asset pricing: Assumptions:
- Individuals can invest in many assets with uncertain returns
o Uncertainty is important to describe asset choices by investors
- Market frictions exists, but are not crucial relative to uncertain returns
- Assume perfectly competitive asset markets (for now)
Traditional CAPM
Based on Markovitz’ theory: Investors are only concerned with the mean and variance of
their portfolio return.
o Expected returns are premiums proportional to market betas (covariance of
asset returns with the returns on the “market portfolio).
- Attractive because it captures risk and returns
- But doesn’t relate to more fundamental needs of investors (e.g. consumption)!
- Simplicity: No need for assuming preferences or risk-aversion of investors
Consumption CAPM
Starts from the basic theory of consumption under uncertainty, but unlike consumption
theory (which takes return on assets as given and derives how much to consume), we take
the consumption as given and derive uncertain return on assets!
- Investors are consumers (Need to eat/buy durables as well)
- Focuses on a consumption beta instead of a market beta to explain expected return
premiums over the risk-free rate
o Consumption beta = covariance between assets return & consumption
- Assets are priced explicitly relative to our utility from consumption
Assumptions:
Utility function:
- Utility function (exogenous; Taken as given)
o 2 key features: Investors are risk-averse & prefers a steady consumption
stream over time/across states of nature
o To avoid volatility in consumption, we need to invest!
- Diminishing marginal utility of consumption: More consumption equals more utility
➔ shown by positive FOC (U'(c_t)>0), but at a declining rate, U''(.)<0 (shown by neg.
SOC).
o 1st Order derivative Marginal Utility of Consumption U’(.)>0; increasing shows
utility is non-saturated (More is always better)
o 2nd Order derivative U”(.)<0 because it’s negative, it shows diminishing
returns for the Marginal utility of consumption
General assumptions:
- Investor can save (to smooth consumption over time) by buying one of i=1…n risky
assets with a net stochastic (random) return of zit or by investing in a risk-free asset
with return rt
