Financial Markets and Asset Pricing

683 Pages·2003·9.305 MB·English

by  G.M. Constantinides, M. Harris and R.M. Stulz (Eds.)

INTRODUCTION TO THE SERIES
The aim of the Handbooks in Economics series is to produce Handbooks for various
branches of economics, each of which is a definitive source, reference, and teaching
supplement for use by professional researchers and advanced graduate students Each
Handbook provides self-contained surveys of the current state of a branch of economics
in the form of chapters prepared by leading specialists on various aspects of this
branch of economics These surveys summarize not only received results but also
newer developments, from recent journal articles and discussion papers Some original
material is also included, but the main goal is to provide comprehensive and accessible
surveys The Handbooks are intended to provide not only useful reference volumes for
professional collections but also possible supplementary readings for advanced courses
for graduate students in economics.
KENNETH J ARROW and MICHAEL D INTRILIGATOR
PUBLISHER'S NOTE
For a complete overview of the Handbooks in Economics Series, please refer to the
listing at the end of this volume.
CONTENTS OF THE HANDBOOK
VOLUME 1A
CORPORATE FINAN-CE
Chapter 1
Corporate Governance and Control
MARCO BECHT, PATRICK BOLTON and AILSA RGELL
Chapter 2
Agency, Information and Corporate Investment
JEREMY C. STEIN
Chapter 3
Corporate Investment Policy
MICHAEL J. BRENNAN
Chapter 4
Financing of Corporations
STEWART C. MYERS
Chapter 5
Investment Banking and Security Issuance
JAY R. RITTER
Chapter 6
Financial Innovation
PETER TUFXNO
Chapter 7
Payout Policy
FRANKLIN ALLEN and RON1 MICHAELY
Chapter 8
Financial Intermediation
GARY GORTON and ANDREW WINTON
Chapter 9
Market Microstructure
HANS R. STOLL
“ill Contents of the Handbook
VOLUME 1B
FINANCIAL MARKETS AND ASSET PRICING
Chapter 10
Arbitrage, State Prices and Portfolio Theory
PHILIP H. DYBVIG and STEPHEN A. ROSS
Chapter II
Intertemporal Asset-Pricing Theory
DARRELL DUFFIE
Chapter 12
Tests of Multi-Factor Pricing Models, Volatility, and Portfolio Performance
WAYNE E. FERSON
Chapter 13
Consumption-Based Asset Pricing
JOHN Y. CAMPBELL
Chapter 14
The Equity Premium in Retrospect
RAJNISH MEHRA and EDWARD C. PRESCOTT
Chapter 15
Anomalies and Market Efficiency
G. WILLIAM SCHWERT
Chapter 16
Are Financial Assets Priced Locally or Globally?
G. ANDREW KAROLYI and RENE M. STULZ
Chapter 17
Microstructure and Asset Pricing
DAVID EASLEY and MAUREEN O’HARA
Chapter 18
A Survey of Behavioral Finance
NICHOLAS C. BARBERIS and RICHARD H. THALER
Finance Optimization, and the Irreducibly Irrational Component of Human Behavior
ROBERT J. SHILLER
Chapter 19
Derivatives
ROBERT E. WHALEY
Chapter 20
Fixed Income Pricing
QIANG DA1 and KENNETH J. SINGLETON
PREFACE
Financial economics applies the techniques of economic analysis to understand the
savings and investment decisions by individuals, the investment, financing and payout
decisions by firms, the level and properties of interest rates and prices of financial
assets and derivatives, and the economic role of financial intermediaries Until the
1950s , finance was viewed primarily as the study of financial institutional detail and
was hardly accorded the status of a mainstream field of economics This perception
was epitomized by the difficulty Harry Markowitz had in receiving a PhD degree in
the economics department at the University of Chicago for work that eventually would
earn him a Nobel prize in economic science This state of affairs changed in the second
half of the 20th century with a revolution that took place from the 1950 S to the early
1970s At that time, key progress was made in understanding the financial decisions
of individuals and firms and their implications for the pricing of common stocks, debt,
and interest rates.
Harry Markowitz, William Sharpe, James Tobin, and others showed how individuals
concerned about their expected future wealth and its variance make investment
decisions Their key results showing the benefits of diversification, that wealth is
optimally allocated across funds that are common across individuals, and that investors
are rewarded for bearing risks that are not diversifiable, are now the basis for much of
the investment industry Merton Miller and Franco Modigliani showed that the concept
of arbitrage is a powerful tool to understand the implications of firm capital structures
for firm value In a world without frictions, they showed that a firm's value is unrelated
to its capital structure Eugene Fama put forth the efficient markets hypothesis and led
the way in its empirical investigation Finally, Fischer Black, Robert Merton and Myron
Scholes provided one of the most elegant theories in all of economics: the theory of
how to price financial derivatives in markets without frictions.
Following the revolution brought about by these fathers of modern finance, the field
of finance has experienced tremendous progress Along the way, it influenced public
policy throughout the world in a major way, played a crucial role in the growth of
a new $ 100 trillion dollar derivatives industry, and affected how firms are managed
everywhere However, finance also evolved from being at best a junior partner in
economics to being often a leader Key concepts and theories first developed in finance
led to progress in other fields of economics It is now common among economists
to use theories of arbitrage, rational expectations, equilibrium, agency relations, and
information asymmetries that were first developed in finance The committee for the
x Preface
Alfred Nobel Memorial Prize in economic science eventually recognized this state of
affairs Markowitz, Merton, Miller, Modigliani, Scholes, Sharpe, and Tobin received
Nobel prizes for contributions in financial economics.
This Handbook presents the state of the field of finance fifty years after this
revolution in modern finance started The surveys are written by leaders in financial
economics They provide a comprehensive report on developments in both theory
and empirical testing in finance at a level that, while rigorous, is nevertheless
accessible to researchers not intimate with the field and doctoral students in economics,
finance and related fields By summarizing the state of the art and pointing out
as-yet unresolved questions, this Handbook should prove an invaluable resource to
researchers planning to contribute to the field and an excellent pedagogical tool for
teaching doctoral students The book is divided into two Volumes, corresponding to
the traditional taxonomy of finance: corporate finance ( 1A ) and financial markets and
asset pricing ( 1B ).
1 Corporate finance
Corporate finance is concerned with how businesses work, in particular, how they
allocate capital (traditionally, "the capital budgeting decision") and how they obtain
capital ("the financing decision") Though managers play no independent role in the
work of Miller and Modigliani, major contributions in finance since then have shown
that managers maximize their own objectives To understand the firm's decisions, it
is therefore necessary to understand the forces that lead managers to maximize the
wealth of shareholders For example, a number of researchers have emphasized the
positive and negative roles of large shareholders in aligning incentives of managers
and shareholders The part of the Handbook devoted to corporate finance starts with an
overview, entitled Corporate Governance and Control, by Marco Becht, Patrick Bolton,
and Ailsa R 6 ell (Chapter 1) of the framework in which managerial activities take place.
Their broad survey covers everything about corporate governance, from its history and
importance to theories and empirical evidence to cross-country comparisons.
Following the survey of corporate governance in Chapter 1, two complementary
essays discuss the investment decision In Agency, Information and Corporate
Investment, Jeremy Stein (Chapter 2) focuses on the effects of agency problems and
asymmetric information on the allocation of capital, both across firms and within firms.
This survey does not address the issue of how to value a proposed investment project,
given information about the project That topic is considered in CorporateI nvestment
Policy by Michael Brennan in Chapter 3 Brennan draws out the implications of
recent developments in asset pricing, including option pricing techniques and tax
considerations, for evaluating investment projects.
In Chapter 4, Financingo f Corporations, the focus moves to the financing decision.
Stewart Myers provides an overview of the research that seeks to explain firms' capital
structure, that is, the types and proportions of securities firms use to finance their
Preface xi
investments Myers covers the traditional theories that attempt to explain proportions
of debt and equity financing as well as more recent theories that attempt to explain
the characteristics of the securities issued In assessing the different capital structure
theories, he concludes that he does not expect that there will ever be "one" capital
structure theory that applies to all firms Rather, he believes that we will always use
different theories to explain the behavior of different types of firms In Chapter 5,
Investment Banking and Security Issuance, Jay Ritter is concerned with how firms
raise equity and the role of investment banks in that process He examines both initial
public offerings and seasoned equity offerings A striking result discovered first by
Ritter is that firms that issue equity experience poor long-term stock returns afterwards.
This result has led to a number of vigorous controversies that Ritter reviews in this
chapter.
Firms may also obtain capital by issuing securities other than equity and debt.
A hallmark of the last thirty years has been the tremendous amount of financial
innovation that has taken place Though some of the innovations fizzled and others
provided fodder to crooks, financial innovation can enable firms to undertake profitable
projects that otherwise they would not be able to undertake In Chapter 6, Financial
Innovation, Peter Tufano delves deeper into the issues of security design and financial
innovation He reviews the process of financial innovation and explanations of the
quantity of innovation.
Investors do not purchase equity without expecting a return from their investment.
In one of their classic papers, Miller and Modigliani show that, in the absence of
frictions, dividend policy is irrelevant for firm value Since then, a large literature has
developed that identifies when dividend policy matters and when it does not Franklin
Allen and Roni Michaely (Chapter 7) survey this literature in their essay entitled
PayoutP olicy Allen and Michaely consider the roles of taxes, asymmetric information,
incomplete contracting and transaction costs in determining payouts to equity holders,
both dividends and share repurchases.
Chapter 8, Financial Intermediation, focuses more directly on the role financial
intermediaries play Although some investment is funded directly through capital
markets, according to Gary Gorton and Andrew Winton, the vast majority of external
investment flows through financial intermediaries In Chapter 8, Gorton and Winton
survey the literature on financial intermediation with emphasis on banking They
explore why intermediaries exist, discuss banking crises, and examine why and how
they are regulated Exchanges on which securities are traded play a crucial role in
intermediating between individuals who want to buy securities and others who want
to sell them In many ways, they are special types of corporations whose workings
affect the value of financial securities as well as the size of financial markets.
The Handbook contains two chapters that deal with the issues of how securities are
traded Market Microstructure, by Hans Stoll (Chapter 9), focuses on how exchanges
perform their functions as financial intermediaries and therefore is included in this
part Stoll examines explanations of the bid-ask spread, the empirical evidence for these
explanations, and the implications for market design Microstructure andA sset Pricing,
xii Preface
by Maureen O'Hara and David Easley (Chapter 17), examines the implications of how
securities trade for the properties of securities returns and is included in Volume 1B
on FinancialM arkets and Asset Pricing.
2 Financial markets and asset pricing
A central theme in finance and economics is the pursuit of an understanding of how
the prices of financial securities are determined in financial markets Currently, there
is immense interest among academics, policy makers, and practitioners in whether
these markets get prices right, fueled in part by the large daily volatility in prices and
by the large increase in stock prices over most of the 1990 s, followed by the sharp
decrease in prices at the turn of the century Our understanding of how securities are
priced is far from complete In the early 1960 s, Eugene Fama from the University
of Chicago established the foundations for the "efficient markets" view that financial
markets are highly effective in incorporating information into asset prices This view
led to a large body of empirical and theoretical work Some of the chapters in this part
of the Handbook review that body of work, but the "efficient markets" view has been
challenged by the emergence of a new, controversial field, behavioral finance, which
seeks to show that psychological biases of individuals affect the pricing of securities.
There is therefore divergence of opinion and critical reexamination of given doctrine.
This is fertile ground for creative thinking and innovation.
In Volume 1B of the Handbook, we invite the reader to partake in this intellectual
odyssey We present eleven original essays on the economics of financial markets.
The divergence of opinion and puzzles presented in these essays belies the incredible
progress made by financial economists over the second half of the 20th century that
lay the foundations for future research.
The modern quantitative approach to finance has its origins in neoclassical
economics In the opening essay titled Arbitrage, State Prices and Portfolio Theory
(Chapter 10), Philip Dybvig and Stephen Ross illustrate a surprisingly large amount
of the intuition and intellectual content of modern finance in the context of a single-
period, perfect-markets neoclassical model They discuss the fundamental theorems
of asset pricing the consequences of the absence of arbitrage, optimal portfolio
choice, the properties of efficient portfolios, aggregation, the capital asset-pricing
model (CAPM), mutual fund separation, and the arbitrage pricing theory (APT).
A number of these notions may be traced to the original contributions of Stephen
Ross.
In his essay titled Intertemporal Asset Pricing Theory (Chapter 11), Darrell Duffie
provides a systematic development of the theory of intertemporal asset pricing, first
in a discrete-time setting and then in a continuous-time setting As applications of the
basic theory, Duffie also presents comprehensive treatments of the term structure of
interest rates and fixed-income pricing, derivative pricing, and the pricing of corporate
securities with default modeled both as an endogenous and an exogenous process.
Preface xiii
These applications are discussed in further detail in some of the subsequent essays.
Duffie's essay is comprehensive and authoritative and may serve as the basis of an
entire 2nd-year PhD-level course on asset pricing.
Historically, the empirically testable implications of asset-pricing theory have been
couched in terms of the mean-variance efficiency of a given portfolio, the validity
of a multifactor pricing model with given factors, or the validity of a given stochastic
discount factor Furthermore, different methodologies have been developed and applied
in the testing of these implications In Tests of Multi-FactorP ricingM odels, Volatility,
and Portfolio Performance (Chapter 12), Wayne Ferson discusses the empirical
methodologies applied in testing asset-pricing models He points out that these three
statements of the empirically testable implications are essentially equivalent and that
the seemingly different empirical methodologies are equivalent as well.
In his essay titled Consumption-Based Asset Pricing (Chapter 13), John Campbell
begins by reviewing the salient features of the joint behavior of equity returns,
aggregate dividends, the interest rate, and aggregate consumption in the USA Features
that challenge existing asset-pricing theory include, but are not limited to, the "equity
premium puzzle": the finding that the low covariance of the growth rate of aggregate
consumption with equity returns is a major stumbling block in explaining the mean
aggregate equity premium and the cross-section of asset returns, in the context of the
representative-consumer, time-separable-preferences models examined by Grossman
and Shiller ( 1981), Hansen and Singleton ( 1983), and Mehra and Prescott (1 985).
Campbell also examines data from other countries to see which features of the USA
data are pervasive He then proceeds to relate these findings to recent developments
in asset-pricing theory that relax various assumptions of the standard asset-pricing
model.
In a closely related essay titled The Equity Premium in Retrospect (Chapter 14),
Rajnish Mehra and Edward Prescott the researchers who coined the term critically
reexamine the data sources used to document the equity premium puzzle in the USA
and other major industrial countries They then proceed to relate these findings to
recent developments in asset-pricing theory by employing the methodological tool of
calibration, as opposed to the standard empirical estimation of model parameters and
the testing of over-identifying restrictions Mehra and Prescott have different views
than Campbell as to which assumptions of the standard asset-pricing model need to
be relaxed in order to address the stylized empirical findings.
Why are these questions important? First and foremost, financial markets play a
central role in the allocation of investment capital and in the sharing of risk Failure to
answer these questions suggests that our understanding of the fundamental process of
capital allocation is highly imperfect Second, the basic economic paradigm employed
in analyzing financial markets is closely related to the paradigm employed in the study
of business cycles and growth Failure to explain the stylized facts of financial markets
calls into question the appropriateness of the related paradigms for the study of macro-
economic issues The above two essays convey correctly the status quo that the puzzle
xiv Preface
is at the forefront of academic interest and that views regarding its resolution are
divergent.
Several goals are accomplished in William Schwert's comprehensive and incisive
essay titled Anomalies and Market Efficiency (Chapter 15) First, Schwert discusses
cross-sectional and time-series regularities in asset returns, both at the aggregate and
disaggregate level These include the size, book-to-market, momentum, and dividend
yield effects Second, Schwert discusses differences in returns realized by different
types of investors, including individual and institutional investors Third, he evaluates
the role of measurement issues in many of the papers that study anomalies, including
the difficult issues associated with long-horizon return performance Finally, Schwert
discusses the implications of the anomalies literature for asset-pricing and corporate
finance theories In discussing the informational efficiency of the market, Schwert
points out that tests of market efficiency are also joint tests of market efficiency and
a particular equilibrium asset-pricing model.
In the essay titled Are FinancialA ssets PricedL ocally or Globally? (Chapter 16),
Andrew Karolyi and Ren 6 Stulz discuss the theoretical implications of and empirical
evidence concerning asset-pricing theory as it applies to international equities markets.
They explain that country-risk premia are determined internationally, but the evidence
is weak on whether international factors affect the cross-section of expected returns.
A long-standing puzzle in international finance is that investors invest more heavily in
domestic equities than predicted by the theory Karolyi and Stulz argue that barriers
to international investment only partly resolve the home-bias puzzle They conclude
that contagion the linkage of international markets may be far less prevalent than
commonly assumed.
At frequencies lower than the daily frequency, asset-pricing theory generally ignores
the role of the microstructure of financial markets In their essay titled Microstructure
and Asset Pricing (Chapter 17), David Easley and Maureen O'Hara survey the
theoretical and empirical literature linking microstructure factors to long-run returns,
and focus on why stock prices might be expected to reflect premia related to liquidity
or informational asymmetries They show that asset-pricing dynamics may be better
understood by recognizing the role played by microstructure factors and the linkages
of microstructure and fundamental economic variables.
All the models that are discussed in the essays by Campbell, Mehra and Prescott,
Schwert, Karolyi and Stulz, and Easley and O'Hara are variations of the neoclassical
asset-pricing model The model is rational, in that investors process information
rationally and have unambiguously defined preferences over consumption Naturally,
the model allows for market incompleteness, market imperfections, informational
asymmetries, and learning The model also allows for differences among assets for
liquidity, transaction costs, tax status, and other institutional factors Many of these
variations are explored in the above essays.
In their essay titled A Survey of Behavioral Finance (Chapter 18), Nicholas
Barberis and Richard Thaler provide a counterpoint to the rational model by providing
explanations of the cross-sectional and time-series regularities in asset returns by
Preface XV
relying on economic models that are less than fully rational These include cultural
and psychological factors and tap into the rich and burgeoning literature on behavioral
economics and finance Robert Shiller, who is, along with Richard Thaler, one of the
founders of behavioral finance, provides his personal perspective on behavioral finance
in his statement titled Finance, Optimization and the Irreducibly IrrationalC omponent
of Human Behavior
One of the towering achievements in finance in the second half of the 20th century is
the celebrated option-pricing theory of Black and Scholes ( 1973) and Merton (1 973).
The model has had a profound influence on the course of economic thought In
his essay titled Derivatives (Chapter 19), Robert Whaley provides comprehensive
coverage of the topic Following a historical overview of futures and options, he
proceeds to derive the implications of the law of one price and then the Black-Scholes-
Merton theory He concludes with a systematic coverage of the empirical evidence
and a discussion of the social costs and benefits associated with the introduction
of derivatives Whaley's thorough and insightful essay provides an easy entry to an
important topic that many economists find intimidating.
In their essay titled Fixed-Income Pricing (Chapter 20), Qiang Dai and Ken
Singleton survey the literature on fixed-income pricing models, including term
structure models, fixed-income derivatives, and models of defaultable securities.
They point out that this literature is vast, with both the academic and practitioner
communities having proposed a wide variety of models In guiding the reader through
these models, they explain that different applications call for different models based on
the trade-offs of complexity, flexibility, tractability, and data availability the "art" of
modeling The Dai and Singleton essay, combined with Duffie's earlier essay, provides
an insightful and authoritative introduction to the world of fixed-income pricing models
at the advanced MBA and PhD levels.
We hope that the contributions represented by these essays communicate the
excitement of financial economics to beginners and specialists alike and stimulate
further research.
We thank Rodolfo Martell for his help in processing the papers for publication.
GEORGE M CONSTANTINIDES
University of Chicago, Chicago
MILTON HARRIS
University of Chicago, Chicago
RENE STULZ
Ohio State University, Columbus
References
Black, E, and M S Scholes (1 973), "The pricing of options and corporate liabilities", Journal of Political
Economy 81:637-654.