Consumption-Based Model and Overview
Consumption-Based Model and Overview
Consumption-Based Model and Overview
1
Consumption-Based Model
and Overview
An investor must decide how much to save and how much to consume,
and what portfolio of assets to hold. The most basic pricing equation
comes from the first-order condition for that decision. The marginal utility
loss of consuming a little less today and buying a little more of the asset
should equal the marginal utility gain of consuming a little more of the
asset’s payoff in the future. If the price and payoff do not satisfy this
relation, the investor should buy more or less of the asset. It follows that
the asset’s price should equal the expected discounted value of the asset’s
payoff, using the investor’s marginal utility to discount the payoff. With
this simple idea, I present many classic issues in finance.
Interest rates are related to expected marginal utility growth, and
hence to the expected path of consumption. In a time of high real inter-
est rates, it makes sense to save, buy bonds, and then consume more
tomorrow. Therefore, high real interest rates should be associated with an
expectation of growing consumption.
Most importantly, risk corrections to asset prices should be driven
by the covariance of asset payoffs with marginal utility and hence by the
covariance of asset payoffs with consumption. Other things equal, an asset
that does badly in states of nature like a recession, in which the investor
feels poor and is consuming little, is less desirable than an asset that does
badly in states of nature like a boom in which the investor feels wealthy
and is consuming a great deal. The former asset will sell for a lower price;
its price will reflect a discount for its “riskiness,” and this riskiness depends
on a co-variance, not a variance.
Marginal utility, not consumption, is the fundamental measure of
how you feel. Most of the theory of asset pricing is about how to go
from marginal utility to observable indicators. Consumption is low when
marginal utility is high, of course, so consumption may be a useful indi-
cator. Consumption is also low and marginal utility is high when the
investor’s other assets have done poorly; thus we may expect that prices
are low for assets that covary positively with a large index such as the mar-
ket portfolio. This is a Capital Asset Pricing Model. We will see a wide
variety of additional indicators for marginal utility, things against which to
compute a convariance in order to predict the risk-adjustment for prices.
u (ct )
Our basic objective is to figure out the value of any stream of uncer-
tain cash flows. I start with an apparently simple case, which turns out to
capture very general situations.
Let us find the value at time t of a payoff xt+1 . If you buy a stock today,
the payoff next period is the stock price plus dividend, xt+1 = pt+1 + dt+1 .
xt+1 is a random variable: an investor does not know exactly how much he
will get from his investment, but he can assess the probability of various
possible outcomes. Do not confuse the payoff xt+1 with the profit or return;
xt+1 is the value of the investment at time t + 1, without subtracting or
dividing by the cost of the investment.
We find the value of this payoff by asking what it is worth to a typical
investor. To do this, we need a convenient mathematical formalism to
capture what an investor wants. We model investors by a utility function
defined over current and future values of consumption,
U (ct
ct+1 ) = u(ct ) + βEt u(ct+1 )
1 1−γ
u(ct ) = c
1−γ t
The limit as γ → 1 is
u(c) = ln(c)
{ξ}
ct = et − pt ξ
ct+1 = et+1 + xt+1 ξ
Substituting the constraints into the objective, and setting the derivative
with respect to ξ equal to zero, we obtain the first-order condition for an
optimal consumption and portfolio choice,
pt u (ct ) = Et βu (ct+1 )xt+1
(1.1)
or
u (ct+1 )
pt = Et β x
(1.2)
u (ct ) t+1
The investor buys more or less of the asset until this first-order condition
holds.
Equation (1.1) expresses the standard marginal condition for an opti-
mum: pt u (ct ) is the loss in utility if the investor buys another unit of
the asset; Et βu (ct+1 )xt+1 is the increase in (discounted, expected) util-
ity he obtains from the extra payoff at t + 1. The investor continues to buy
or sell the asset until the marginal loss equals the marginal gain.
Equation (1.2) is the central asset pricing formula. Given the payoff
xt+1 and given the investor’s consumption choice ct
ct+1 , it tells you what
market price pt to expect. Its economic content is simply the first-order
conditions for optimal consumption and portfolio formation. Most of the
theory of asset pricing just consists of specializations and manipulations
of this formula.
We have stopped short of a complete solution to the model, i.e., an
expression with exogenous items on the right-hand side. We relate one
endogenous variable, price, to two other endogenous variables, consump-
tion and payoffs. One can continue to solve this model and derive the
optimal consumption choice ct
ct+1 in terms of more fundamental givens
of the model. In the model I have sketched so far, those givens are the
income sequence et
et+1 and a specification of the full set of assets that
the investor may buy and sell. We will in fact study such fuller solutions
below. However, for many purposes one can stop short of specifying (pos-
sibly wrongly) all this extra structure, and obtain very useful predictions
about asset prices from (1.2), even though consumption is an endogenous
variable.
u (ct+1 )
m=β
u (ct )
where mt+1 is the stochastic discount factor.
pt = Et (mt+1 xt+1 )
(1.4)
1
pt = x
(1.5)
Rf t+1
where Rf is the gross risk-free rate. 1/Rf is the discount factor. Since gross
interest rates are typically greater than one, the payoff xt+1 sells “at a
discount.” Riskier assets have lower prices than equivalent risk-free assets,
so they are often valued by using risk-adjusted discount factors,
1 i
pit = E x
Ri t t+1
Here, I have added the i superscript to emphasize that each risky asset i
must be discounted by an asset-specific risk-adjusted discount factor 1/Ri .
In this context, equation (1.4) is obviously a generalization, and it says
something deep: one can incorporate all risk corrections by defining a sin-
gle stochastic discount factor—the same one for each asset—and putting it
inside the expectation. mt+1 is stochastic or random because it is not known
with certainty at time t. The correlation between the random components
of the common discount factor m and the asset-specific payoff xi generate
asset-specific risk corrections.
mt+1 is also often called the marginal rate of substitution after (1.3). In
that equation, mt+1 is the rate at which the investor is willing to substitute
consumption at time t + 1 for consumption at time t. mt+1 is sometimes
also called the pricing kernel. If you know what a kernel is and you express
the expectation as an integral, you can see where the name comes from.
It is sometimes called a change of measure or a state-price density.
For the moment, introducing the discount factor m and breaking the
basic pricing equation (1.2) into (1.3) and (1.4) is just a notational conve-
nience. However, it represents a much deeper and more useful separation.
For example, notice that p = E(mx) would still be valid if we changed
the utility function, but we would have a different function connecting m
to data. All asset pricing models amount to alternative ways of connect-
ing the stochastic discount factor to data. At the same time, we will study
lots of alternative expressions of p = E(mx), and we can summarize many
empirical approaches by applying them to p = E(mx). By separating our
models into these two components, we do not have to redo all that elab-
oration for each asset pricing model.
The price pt gives rights to a payoff xt+1 . In practice, this notation covers
a variety of cases, including the following:
Price pt Payoff xt+1
The price pt and payoff xt+1 seem like a very restrictive kind of secu-
rity. In fact, this notation is quite general and allows us easily to accom-
modate many different asset pricing questions. In particular, we can cover
stocks, bonds, and options and make clear that there is one theory for all
asset pricing.
For stocks, the one-period payoff is of course the next price plus divi-
dend, xt+1 = pt+1 + dt+1 . We frequently divide the payoff xt+1 by the price
pt to obtain a gross return
xt+1
Rt+1 ≡
pt
We can think of a return as a payoff with price one. If you pay one dollar
today, the return is how many dollars or units of consumption you get
tomorrow. Thus, returns obey
1 = E(mR)
which is by far the most important special case of the basic formula
p = E(mx). I use capital letters to denote gross returns R, which have
a numerical value like 1.05. I use lowercase letters to denote net returns
r = R − 1 or log (continuously compounded) returns r = ln(R), both of
which have numerical values like 0.05. One may also quote percent returns
100 × r.
Returns are often used in empirical work because they are typically
stationary over time. (Stationary in the statistical sense; they do not have
trends and you can meaningfully take an average. “Stationary” does not
mean constant.) However, thinking in terms of returns takes us away from
the central task of finding asset prices. Dividing by dividends and creating
a payoff of the form
pt+1 dt+1
xt+1 = 1 +
dt+1 dt
where denotes the price level (cpi). Obviously, this is the same as defin-
ing a nominal discount factor by
u (ct+1 ) t
pt = Et β x
To accommodate all these cases, I will simply use the notation price pt
and payoff xt+1 . These symbols can denote 0
1
or zt and Ret
rt+1 ,
or zt Rt+1 , respectively, according to the case. Lots of other definitions of
p and x are useful as well.
Risk-Free Rate
2 t
Real interest rates are high when people are impatient (δ), when
expected consumption growth is high (intertemporal substitution), or when
risk is low (precautionary saving). A more curved utility function (γ) or a
lower elasticity of intertemporal substitution (1/γ) means that interest rates
are more sensitive to changes in expected consumption growth.
Rf = 1/E(m)
(1.6)
β ct
1. Real interest rates are high when people are impatient, i.e. when β is
low. If everyone wants to consume now, it takes a high interest rate to
convince them to save.
2. Real interest rates are high when consumption growth is high. In times
of high interest rates, it pays investors to consume less now, invest more,
and consume more in the future. Thus, high interest rates lower the
level of consumption today, while raising its growth rate from today to
tomorrow.
f γ2 2
rt = δ + γEt (! ln ct+1 ) − σ (! ln ct+1 )
(1.7)
2 t
f
where I have defined the log risk-free rate rt and subjective discount rate δ
by
f f
rt = ln Rt ; β = e−δ
! ln ct+1 = ln ct+1 − ln ct
ct
Using the fact that normal z means
2
E ez = eE(z)+(1/2)σ (z)
(you can check this by writing out the integral that defines the expecta-
tion), we have
f 2 2 −1
Rt = e−δ e−γEt (! ln ct+1 )+(γ /2)σt (! ln ct+1 )
more worried about the low consumption states than they are pleased by
the high consumption states. Therefore, people want to save more, driv-
ing down interest rates.
We can also read the same terms backwards: consumption growth is
high when real interest rates are high, since people save more now and
spend it in the future, and consumption is less sensitive to interest rates
as the desire for a smooth consumption stream, captured by γ, rises. Sec-
tion 2.2 takes up the question of which way we should read this equation—
as consumption determining interest rates, or as interest rates determin-
ing consumption.
For the power utility function, the curvature parameter γ simulta-
neously controls intertemporal substitution—aversion to a consumption
stream that varies over time, risk aversion—aversion to a consumption
stream that varies across states of nature, and precautionary savings, which
turns out to depend on the third derivative of the utility function. This
link is particular to the power utility function. More general utility func-
tions loosen the links between these three quantities.
Risk Corrections
p = E(m)E(x) + cov(m
x)
(1.8)
E(x)
p= + cov(m
x)
(1.9)
Rf
The first term in (1.9) is the standard discounted present-value for-
mula. This is the asset’s price in a risk-neutral world—if consumption is
constant or if utility is linear. The second term is a risk adjustment. An
asset whose payoff covaries positively with the discount factor has its price
raised and vice versa.
To understand the risk adjustment, substitute back for m in terms of
consumption, to obtain
E(x) cov βu (ct+1 )
xt+1
p= +
(1.10)
Rf u (ct )
Marginal utility u (c) declines as c rises. Thus, an asset’s price is lowered if
its payoff covaries positively with consumption. Conversely, an asset’s price
is raised if it covaries negatively with consumption.
Why? Investors do not like uncertainty about consumption. If you
buy an asset whose payoff covaries positively with consumption, one that
pays off well when you are already feeling wealthy, and pays off badly
when you are already feeling poor, that asset will make your consumption
stream more volatile. You will require a low price to induce you to buy
such an asset. If you buy an asset whose payoff covaries negatively with
consumption, it helps to smooth consumption and so is more valuable
than its expected payoff might indicate. Insurance is an extreme example.
Insurance pays off exactly when wealth and consumption would otherwise
be low—you get a check when your house burns down. For this reason,
you are happy to hold insurance, even though you expect to lose money—
even though the price of insurance is greater than its expected payoff
discounted at the risk-free rate.
To emphasize why the covariance of a payoff with the discount factor
rather than its variance determines its riskiness, keep in mind that the
investor cares about the volatility of consumption. He does not care about
the volatility of his individual assets or of his portfolio, if he can keep
a steady consumption. Consider then what happens to the volatility of
consumption if the investor buys a little more ξ of payoff x. σ 2 (c) becomes
1 = E(mRi )
The asset pricing model says that, although expected returns can vary
across time and assets, expected discounted returns should always be the
same, 1. Applying the covariance decomposition,
or
i f
cov u (ct+1 )
Rit+1
E(R ) − R = −
(1.13)
E u (ct+1 )
All assets have an expected return equal to the risk-free rate, plus a
risk adjustment. Assets whose returns covary positively with consumption
make consumption more volatile, and so must promise higher expected
returns to induce investors to hold them. Conversely, assets that covary
negatively with consumption, such as insurance, can offer expected rates
of return that are lower than the risk-free rate, or even negative (net)
expected returns.
Much of finance focuses on expected returns. We think of expected
returns increasing or decreasing to clear markets; we offer intuition that
“riskier” securities must offer higher expected returns to get investors to
hold them, rather than saying “riskier” securities trade for lower prices
so that investors will hold them. Of course, a low initial price for a given
payoff corresponds to a high expected return, so this is no more than a
different language for the same phenomenon.
You might think that an asset with a volatile payoff is “risky” and thus
should have a large risk correction. However, if the payoff is uncorrelated
with the discount factor m, the asset receives no risk correction to its price,
cov(m x) = 0
then
E(x)
p=
Rf
no matter how large σ 2 (x). This prediction holds even if the payoff x is
highly volatile and investors are highly risk averse. The reason is simple:
if you buy a little bit more of such an asset, it has no first-order effect on
the variance of your consumption stream.
More generally, one gets no compensation or risk adjustment for hold-
ing idiosyncratic risk. Only systematic risk generates a risk correction. To
give meaning to these words, we can decompose any payoff x into a part
correlated with the discount factor and an idiosyncratic part uncorrelated
with the discount factor by running a regression,
x = proj(x|m) + ε
Then, the price of the residual or idiosyncratic risk ε is zero, and the
price of x is the same as the price of its projection on m. The projection
of x on m is of course that part of x which is perfectly correlated with m.
The idiosyncratic component of any payoff is that part uncorrelated with m.
Thus only the systematic part of a payoff accounts for its price.
Projection means linear regression without a constant,
E(mx)
proj(x|m) = m
E(m2 )
You can verify that regression residuals are orthogonal to right-hand vari-
ables E(mε) = 0 from this definition. E(mε) = 0 of course means that
the price of ε is zero,
E(mx) 2 E(mx)
p(proj(x|m)) = p m = E m = E(mx) = p(x)
E(m2 ) E(m2 )
The words “systematic” and “idiosyncratic” are defined differently in
different contexts, which can lead to some confusion. In this decomposi-
tion, the residuals ε can be correlated with each other, though they are not
correlated with the discount factor. The APT starts with a factor-analytic
decomposition of the covariance of payoffs, and the word “idiosyncratic”
there is reserved for the component of payoffs uncorrelated with all of
the other payoffs.
E(Ri ) = Rf + βi m λm (1.15)
Mean-Variance Frontier
All asset returns lie inside a mean-variance frontier. Assets on the fron-
tier are perfectly correlated with each other and with the discount factor.
Returns on the frontier can be generated as portfolios of any two frontier
returns. We can construct a discount factor from any frontier return (except
Rf ), and an expected return-beta representation holds using any frontier
return (except Rf ) as the factor.
Asset pricing theory has focused a lot on the means and variances of
asset returns. Interestingly, the set of means and variances of returns is
limited. All assets priced by the discount factor m must obey
E(Ri ) − Rf ≤ σ (m) σ (Ri )
(1.17)
E(m)
and hence
σ (m)
E(Ri ) = Rf − ρm
Ri σ (Ri )
(1.18)
E(m)
Figure 1.1. Mean-variance frontier. The mean and standard deviation of all assets priced
by a discount factor m must lie in the wedge-shaped region.
3. All frontier returns are also perfectly correlated with each other,
since they are all perfectly correlated with the discount factor. This
fact implies that we can span or synthesize any frontier return from
two such returns. For example, if you pick any single frontier return
Rm , then all frontier returns Rmv must be expressible as
Rmv = Rf + a Rm − Rf
m = a + bRmv
Rmv = d + em
Thus, any mean-variance efficient return carries all pricing information. Given
a mean-variance efficient return and the risk-free rate, we can find a
discount factor that prices all assets and vice versa.
5. Given a discount factor, we can also construct a single-beta representa-
tion, so expected returns can be described in a single-beta representation using
any mean-variance efficient return (except the risk-free rate),
E(Ri ) = Rf + βi
mv E(Rmv ) − Rf
The essence of the beta pricing model is that, even though the means
and standard deviations of returns fill out the space inside the mean-
variance frontier, a graph of mean returns versus betas should yield a
straight line. Since the beta model applies to every return including
Rmv itself, and Rmv has a beta of 1 on itself, we can identify the factor
risk premium as λ = E(Rmv − Rf ).
The last two points suggest an intimate relationship between discount
factors, beta models, and mean-variance frontiers. I explore this rela-
tion in detail in Chapter 6. A problem at the end of this chapter guides
you through the algebra to demonstrate points 4 and 5 explicitly.
6. We can plot the decomposition of a return into a “priced” or “sys-
tematic” component and a “residual,” or “idiosyncratic” component as
shown in Figure 1.1. The priced part is perfectly correlated with the dis-
count factor, and hence perfectly correlated with any frontier return.
The residual or idiosyncratic part generates no expected return, so it
lies flat as shown in the figure, and it is uncorrelated with the discount
factor or any frontier return. Assets inside the frontier or even on the
lower portion of the frontier are not “worse” than assets on the fron-
tier. The frontier and its internal region characterize equilibrium asset
returns, with rational investors happy to hold all assets. You would not
want to put your whole portfolio in one “inefficient” asset, but you are
happy to put some wealth in such assets.
The Sharpe ratio is limited by the volatility of the discount factor. The
maximal risk-return trade-off is steeper if there is more risk or more risk
aversion,
E(R) − Rf σ (m)
σ (R) ≤ E(m) ≈ γσ (! ln c)
This formula captures the equity premium puzzle, which suggests that either
people are very risk averse, or the stock returns of the last 50 years were
good luck which will not continue.
into a security, you can increase the mean return of your position, but you
do not increase the Sharpe ratio, since the standard deviation increases
at the same rate as the mean.
The slope of the mean-standard deviation frontier is the largest avail-
able Sharpe ratio, and thus is naturally interesting. It answers “how much
more mean return can I get by shouldering a bit more volatility in my
portfolio?”
Let Rmv denote the return of a portfolio on the frontier. From
equation (1.17), the slope of the frontier is
E(Rmv ) − Rf σ (m)
f
σ (Rmv ) = E(m) = σ (m)R
Thus, the slope of the frontier is governed by the volatility of the discount
factor.
For an economic interpretation, again consider the power utility func-
tion, u (c) = c−γ ,
E(Rmv ) − Rf σ (ct+1 /ct )−γ
σ (Rmv ) = Ec /c −γ
(1.19)
t+1 t
E(Rmv ) − Rf
γ 2 σ 2 (! ln ct+1 )
σ (Rmv ) = e − 1 ≈ γσ (! ln c)
(1.20)
(A problem at the end of the chapter guides you through the algebra
of the first equality. The relation is exact in continuous time, and thus
the approximation is easiest to derive by reference to the continuous-time
result; see Section 1.5.)
Reading the equation, the slope of the mean-standard deviation frontier is
higher if the economy is riskier—if consumption is more volatile—or if investors
are more risk averse. Both situations naturally make investors more reluc-
tant to take on the extra risk of holding risky assets. Both situations also
raise the slope of the expected return-beta line of the consumption beta
model, (1.16). (Or, conversely, in an economy with a high Sharpe ratio,
low risk-aversion investors should take on so much risk that their con-
sumption becomes volatile.)
In postwar U.S. data, the slope of the historical mean-standard devi-
ation frontier, or of average return-beta lines, is much higher than rea-
sonable risk aversion and consumption volatility estimates suggest. This is
the “equity premium puzzle.” Over the last 50 years in the United States,
If investors are risk neutral, returns are unpredictable, and prices follow
martingales. In general, prices scaled by marginal utility are martingales, and
returns can be predictable if investors are risk averse and if the conditional
second moments of returns and discount factors vary over time. This is more
plausible at long horizons.
pt = Et (pt+1 )
pt+1 = pt + εt+1
If the variance σt2 (εt+1 ) is constant, prices follow a random walk. More
generally, prices follow a martingale. Intuitively, if the price today is a lot
lower than investors’ expectations of the price tomorrow, then investors
will try to buy the security. But this action will drive up the price of the
security until the price today does equal the expected price tomorrow.
Another way of saying the same thing is that returns should not be pre-
dictable; dividing by pt , expected returns Et (pt+1 /pt ) = 1 should be con-
stant; returns should be like coin flips.
The more general equation (1.21) says that prices should follow a mar-
tingale after adjusting for dividends and scaling by marginal utility. Since
martingales have useful mathematical properties, and since risk neutral-
ity is such a simple economic environment, many asset pricing results are
easily derived by scaling prices and dividends by discounted marginal util-
ity first, and then using “risk-neutral” formulas and risk-neutral economic
arguments.
Since consumption and risk aversion do not change much day to day,
we might expect the random walk view to hold pretty well on a day-to-day
basis. This idea contradicts the still popular notion that there are “sys-
tems” or “technical analysis” by which one can predict where stock prices
are going on any given day. The random walk view has been remarkably
successful. Despite decades of dredging the data, and the popularity of
media reports that purport to explain where markets are going, trading
rules that reliably survive transactions costs and do not implicitly expose
the investor to risk have not yet been reliably demonstrated.
However, more recently, evidence has accumulated that long-horizon
excess returns are quite predictable, and to some this evidence indicates
that the whole enterprise of economic explanation of asset returns is
flawed. To think about this issue, write our basic equation for expected
returns as
f cov t (mt+1
Rt+1 )
Et (Rt+1 ) − Rt = −
Et (mt+1 )
σt (mt+1 )
= σ (R )ρ (m
R ) (1.22)
Et (mt+1 ) t t+1 t t+1 t+1
≈ γt σt (!ct+1 )σt (Rt+1 )ρt (mt+1
Rt+1 )
Present-Value Statement
∞
pt = Et mt
t+j dt+j
j=0
j=0
You can see that if this equation holds at time t and time t + 1, then
we can derive the two-period version
f
where Rt
t+j ≡ Et (mt
t+j )−1 is the j period interest rate. Again, assets
whose dividend streams covary negatively with marginal utility, and posi-
tively with consumption, have lower prices, since holding those assets gives
the investor a more volatile consumption stream. (It is common instead
to write prices
as ai discounted value using a risk-adjusted discount factor,
e.g., pit = ∞ E d
j=1 t t+j /(R i j
) , but this approach is difficult to use correctly
for multiperiod problems, especially when expected returns can vary over
time.)
At a deeper level, the expectation in the two-period formula p =
E(mx) sums over states of nature. Equation (1.23) just sums over time as
well and is mathematically identical.
Discrete Continuous
∞ u (ct+j )
∞
pt = Et βj
Dt+j pt u (ct ) = Et e−δs u (ct+s )Dt+s ds
j=1 u (ct ) s=0
u (ct+1 )
mt+1 = β *t = e−δt u (ct )
u (ct )
p = E(mx) 0 = *D dt + Et [d(*p)]
dp D f d* dp
E(R) = Rf − Rf cov(m
R) Et + dt = rt dt − Et
p p * p
pt pt
We model the price of risky assets as diffusions, for example,
dpt
= µ(·) dt + σ (·) dz
pt
(I use the notation dz for increments to a standard Brownian motion, e.g.,
zt+! − zt ∼ N (0
!). I use the notation (·) to indicate that the drift and
diffusions µ and σ can be functions of state variables. I limit the discus-
sion to diffusion processes—no jumps.) What is nice about this diffusion
model is that the increments dz are normal. However, the dependence of
µ and σ on state variables means that the finite-time distribution of prices
f (pt+! |It ) need not be normal.
We can think of a risk-free security as one that has a constant price
equal to 1 and pays the risk-free rate as a dividend,
f
p=1 Dt = rt
(1.25)
t=0
Suppose the investor can buy a security whose price is pt and that pays a
dividend stream Dt . As we did in deriving the present-value price relation
in discrete time, the first-order condition for this problem gives us the
infinite-period version of the basic pricing equation right away,1
∞
pt u (ct ) = Et e−δs u (ct+s )Dt+s ds
(1.27)
s=0
1
One unit of the security pays the dividend stream Dt , i.e., Dt dt units of the numeraire
consumption good in a time interval dt. The security costs pt units of the consumption good.
The investor can finance the purchase of ξ units of the security by reducing consumption
from et to ct = et − ξpt /dt during time interval dt. The loss in utility from doing so is
u (ct )(et − ct ) dt = u (ct )ξpt . The gain is the right-hand side of (1.27) multiplied by ξ.
*t ≡ e−δt u (ct )
(Some people like to define *t = u (ct ), in which case you keep the e−δt
in the equation. Others
s
like to scale *t by the risk-free rate, in which case
f
you get an extra e− τ =0 rt+τ dτ in the equation. The latter procedure makes
it look like a risk-neutral or present-value formula valuation.)
The analogue to the one-period pricing equation p = E(mx) is
0 = *D dt + Et d(*p)
(1.29)
s=0
Canceling pt *t ,
0 ≈ *t Dt ! + Et (*t+! pt+! − *t pt )
d(*p) = p d* + * dp + dp d*
(1.32)
Using the expanded version (1.32) in the basic equation (1.29), and divid-
ing by p* to make it pretty, we obtain an equivalent, slightly less compact
but slightly more intuitive version,
D d* dp d* dp
0= dt + Et + +
(1.33)
p * p * p
(This formula only works when both * and p can never be zero. It is often
enough the case that this formula is useful. If not, multiply through by *
and p and keep them in numerators.)
Applying the basic pricing equations (1.29) or (1.33) to a risk-free
rate, defined as (1.25) or (1.26), we obtain
f d*t
rt dt = −Et
(1.34)
*t
This equation is the obvious continuous-time equivalent to
f 1
Rt =
Et (mt+1 )
If a risk-free rate is not traded, we can use (1.34) to define a shadow risk-
free rate or zero-beta rate.
With this interpretation, we can rearrange equation (1.33) as
dpt Dt f d*t dpt
Et + dt = rt dt − Et
(1.35)
pt pt *t pt
E(R) = Rf − Rf cov(m
R)
(1.36)
The last term in (1.35) is the covariance of the return with the discount
factor or marginal utility. Since means are order dt, there is no difference
between covariance and second moment in the last term of (1.35). The
interest rate component of the last term of (1.36) naturally vanishes as
the time interval gets short.
Ito’s lemma makes many transformations simple in continuous time.
For example, the nonlinear transformation between consumption and the
discount factor led us to some tricky approximations in discrete time. This
transformation is easy in continuous time (diffusions are locally normal,
so it is really the same trick). With *t = e−δt u (ct ) we have
1
d*t = −δe−δt u (ct ) dt + e−δt u (ct ) dct + e−δt u (ct ) dc2t
2
(1.37)
d*t ct u (ct ) dct 1 c2t u (ct ) dc2t
= −δ dt + +
u (ct )
(For power utility, the former is the power coefficient γ and the latter is
ηt = γ(γ + 1).)
Using this formula we can quickly redo the relationship between inter-
est rates and consumption growth, equation (1.7),
2
f 1 d*t 1 dct 1 1 dct
rt = − E t = δ + γ t Et − ηt E t
dt *t dt ct 2 dt c2t
We can also easily express asset prices in terms of consumption risk
rather than discount factor risk, as in equation (1.16). Using (1.37) in
(1.35),
dpt Dt f dct dpt
Et + dt − rt dt = γEt
(1.38)
pt pt ct pt
Thus, assets whose returns covary more strongly with consumption get
higher mean excess returns, and the constant relating covariance to mean
return is the utility curvature coefficient γ.
Problems 33
Since correlations are less than 1, equation (1.38) implies that Sharpe
ratios are related to utility curvature and consumption volatility directly;
we do not need the ugly lognormal facts and an approximation that we
needed in (1.20). Using µp ≡ Et (dpt /pt ); σp2 = Et [(dpt /pt )2 ]; σc2 =
Et [(dct /ct )2 ],
Dt f
µp + pt
dt − rt dt
≤ γσc
σp
Problems—Chapter 1
1.
(a) The absolute risk-aversion coefficient is
u (c)
u (c)
We scale by u (c) because expected utility is only defined up to linear
transformations—a + bu(c) gives the same predictions as u(c)—and this
measure of the second derivative is invariant to linear transformations.
Show that the utility function with constant absolute risk aversion is
u(c) = −e−αc
u (c)
For power utility u (c) = c−γ , show that the risk-aversion coefficient
equals the power.
(c) The elasticity of intertemporal substitution is defined in a non-
stochastic model with interest rate R as
c2 /c1 d(c1 /c2 )
ξI ≡ −
dR/R
Show that with power utility u (c) = c−γ , the intertemporal substitution
elasticity is equal to 1/γ. (Hint: differentiate the first-order conditions)
2. Show that the “idiosyncratic risk” line in Figure 1.1 is horizontal.
3.
(a) Suppose you have a mean–variance efficient return Rmv and the
risk-free rate. Using the fact that Rmv is perfectly correlated with the
(b) Using this result, and the beta model in terms of m, show that
expected returns can be described in a single-beta representation using
any mean-variance efficient return (except the risk-free rate).
E(Ri ) = Rf + βi
mv E(Rmv ) − Rf
4. Can the “Sharpe ratio” between two risky assets exceed the slope of
the mean-variance frontier? That is, if Rmv is on the frontier, is it possible
that
t+1 t
(Start with σ 2 (x) = E(x2 ) − E(x)2 and the lognormal property E(ez ) =
2
eEz+(1/2)σ (z) .)
6. There are assets with mean return equal to the risk-free rate, but
substantial standard deviation of returns. Long-term bonds are pretty close
examples. Why would anyone hold such an asset? Wouldn’t it be better to
put your money in a mean-variance frontier asset?
7. The first-order conditions for an infinitely lived investor who can buy
an asset with dividend stream {dt } are
∞
u (ct+j )
pt = Et βj d
(1.39)
j=1 u (ct ) t+j
The first-order conditions for buying a security with price pt and payoff
xt+1 = dt+1 + pt+1 are
u (c )
pt = Et β t+1 pt+1 + dt+1
(1.40)
u (ct )
Problems 35
1 = E(mR)
show that the negative of the mean log discount factor must be larger
than any mean return,
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