Risk Based Asset Pricing Flashcards
(18 cards)
What is the role of risk and investors’ risk aversion in asset pricing approaches assuming efficient markets?
In asset pricing approaches assuming efficient markets, risk is measured by how an asset’s returns co-vary with consumption—assets that perform poorly in bad times are considered riskier. Investors dislike such risk and, due to their risk aversion, demand higher expected returns (risk premia) to hold these assets. The degree of risk aversion determines how much compensation investors require, shaping equilibrium asset prices through the stochastic discount factor.
Key Idea of risk based asset pricing
i) Intertemporal consumption choice
-> Lifetime utility
ii) Risk return trade off
-> dislike uncertainty in consumption
SDF?
The Stochastic Discount Factor
- adjusts asset return for risk and time preferences
- SDF is low in good times
- SDF is high in bad times
Asset price reflects payoff covariance with consumption growth
E(Rt+1) - Rf = -lambda * com(mt+1,Rt+1)
- Assets that covary positively with returns, pay off in bad times, unconditional of the state they have low return, high price, low premium.
- Assets that covary negatively with returns, pay off in good times are risky. High premium, low prices, high returns.
-> Investors care about consumption risk
Equity Premium Puzzle
E(Re - Rf) = gamma*sigma(Ct)
The high equity premium cannot be explained by traditional consumption based CAPM.
Empirically the coefficient of relative risk aversion is not large enough to justify such high equity premia.
Solutions to Equity Premium Puzzle
- Rare Disaster Risk
- Habit Formation
3 Other Risk Factors
Rare Disaster Risk
With prob p, consumption contracts by a fraction b. Stocks are exposed to this risk. Investors require higher premium for risk bearing.
When calibrated in line with theory
But disaster risk hard to estimate accurately and still requires high risk aversion.
Stocks are more exposed to this risk than e.g. bonds, which increases equity premium.
- Still requires high gamma
- hard to estimate disaster probability
Habit formation
Agents derive utility from excess consumption over a habit stock. Habit stock is a fraction lambda of last periods consumption. Effective risk aversion is endogenous, and countercyclical. Risk aversion increases as consumption falls.
+ Time varying risk premia in line with business cycle variations
+ Explains return predictability, when consumption is low, real to habits, future excess returns are high
- Requires high habit persistence
- Difficult to test directly
More Risk Factors
Investors do not only insure against consumption risk but also care about other risk factors
- long run consumption
- liquidity
- political risk
- climate risk
- Many of them not micro founded
- factor zoo, data mining and overfitting issues
Evidence from Micro Data. What is it that people really respond to when making investment decisions?
Respondents (broad spectrum representative of participants in the stock market) respond to risk and return consistent with textbook logic, but do not invest more if correlation with consumption growth is more negative.
They respond to mean return, and volatility in line with textbook
If they care about consumption growth it is contrary to textbook logic
What does Correlation with Consumption growth mean
If an assets return is positively correlated with consumption growth, then it pays off in good times, SDF is low.
If an asset is negatively correlated with consumption growth it pays off in bad times, SDF high.
Disregard of textbook logic implies investors use other methods to make decisions. What are they? (2)
Heuristics and rules of thumb
- Disposition, based on past performance
- Home bias
- Naive diversification
Do financial professionals also make investment decisions based on heuristics?
Study that compares post-trade performance of financial professionals to a random buy/sell strategy.
- Buying assets does not depend on past performance
- Selling assets depends on past performance. Selling extreme positions
-> These heuristic decisions are associated with losses
How can CAPM be rescued
X-CAPM:
Two types of investors
- extrapolators
- rational investors
Accounts for:
- p/d ratio expected returns
- high volatility
- Disagreement and extrapolation
But not high equity premium
How can CAPM be rescued pt2
Non rational expectation formation about fundamentals
Does not require exotic risk
Movements in expected earnings rather than discount rates explain asset price swings
Price Anomalies
Equity premium puzzle
Return Predictability
Not based on consumption risk
Belief anomalies
False non-consideration of correlation with consumption growth
Use of heuristics and rules of thumb
Non rational belief patterns lead to mispricing
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