CONTENTS OF VOLUME IB

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1 CONTENTS OF VOLUME IB Introduction to the Series Contents of the Handbook Preface v vii ix FINANCIAL MARKETS AND ASSET PRICING Chapter 10 Arbitrage, State Prices and Portfolio Theory PHILIP H. DYBVIG and STEPHEN A. ROSS 605 Abstract 606 Keywords Introduction Portfolio problems Absence of arbitrage and preference-free results Fundamental theorem of asset pricing " Pricing rule representation theorem Various analyses: Arrow-Debreu world Optimal portfolio choice Efficient portfolios Aggregation Asset pricing Payoff distribution pricing Capital asset pricing model (CAPM) Mutual fund separation theory Preference approach Beliefs Arbitrage pricing theory (APT) Conclusion 634 References 634 Chapter 11 Intertemporal Asset Pricing Theory DARRELL DUFFIE 639 Abstract 641

2 xviii Contents of Volume IB Keywords, Introduction Basic theory Setup Arbitrage, state prices, and martingales Individual agent optimality Habit and recursive utilities Equilibrium and Pareto optimality Equilibrium asset pricing Breeden's consumption-based CAPM Arbitrage and martingale measures Valuation of redundant securities American exercise policies and valuation Continuous-time modeling Trading gains for Brownian prices ' Martingale trading gains The Black-Scholes option-pricing fonnula Ito's Formula Arbitrage modeling Numeraire invariance State prices and doubling strategies Equivalent martingale measures Girsanov and market prices of risk Black-Scholes again 676 \ Complete markets Optimal trading and consumption Martingale solution to Merton's problem Term-structure models One-factor models Term-structure derivatives Fundamental solution Multifactor term-structure models Affine models The HJM model of forward rates Derivative pricing Forward and futures prices Options and stochastic volatility Option valuation by transform analysis i Corporate securities Endogenous default timing Example: Brownian dividend growth Taxes, bankruptcy costs, capital structure Intensity-based modeling of default 719

3 Contents of Volume IB xix 6.5. Zero-recovery bond pricing Pricing with recovery at default Default-adjusted short rate 724 References 725 Chapter 12 Tests of Multifactor Pricing Models, Volatility Bounds and Portfolio Performance WAYNE E. FERSON 743 Abstract 745 Keywords Introduction Multifactor asset-pricing models: Review and integration The stochastic discount factor representation Expected risk premiums Return predictability Consumption-based asset-pricing models Multi-beta pricing models Mean-variance efficiency with conditioning information Choosing the factors Modern variance bounds The Hansen-Jagannathan bounds Variance bounds with conditioning information The Hansen-Jagannathan distance Methodology and tests of multifactor asset-pricing models The Generalized Method of Moments approach Cross-sectional regression methods Multivariate regression and beta-pricing models Conditional performance evaluation Stochastic discount factor formulation Beta-pricing formulation Using portfolio weights Conditional market-timing models Empirical evidence on conditional performance Conclusions 794 References 795 Chapter 13 Consumption-Based Asset Pricing JOHN Y. CAMPBELL 803 Abstract 804 Keywords Introduction 805

4 xx Contents of Volume IB 2. International stock market data The equity premium puzzle The stochastic discount factor " Consumption-based asset pricing with power utility The risk-free rate puzzle Bond returns and the equity-premium and risk-free rate puzzles Separating risk aversion and intertemporal substitution The dynamics of asset returns and consumption Time-variation in conditional expectations A loglinear asset-pricing framework The equity volatility puzzle Implications for the equity premium puzzle What does the stock market forecast? Changing volatility in stock returns What does the bond market forecast? ' Cyclical variation in the price of risk Habit formation Models with heterogeneous agents Irrational expectations Some implications for macroeconomics 879 References ' 881 Chapter 14 The Equity Premium in Retrospect ^RAJNISH MEHRA and EDWARD C. PRESCOTT 889 Abstract 890 Keywords Introduction The equity premium: history Facts Data sources Estimates of the equity premium Variation in the equity premium over time Is the equity premium due to a premium for bearing non-diversifiable risk? Standard preferences Estimating the equity risk premium versus estimating the risk aversion parameter Alternative preference structures Idiosyncratic and uninsurable income risk 918 '3.5. Models incorporating a disaster state and survivorship bias Is the equity premium due to borrowing constraints, a liquidity premium or taxes? Borrowing constraints Liquidity premium 924

5 Contents of Volume IB xxl 4.3. Taxes and regulation An equity premium in the future? 927 Appendix A 928 Appendix B. The original analysis of the equity premium puzzle 930 B.I. The economy, asset prices and returns 930 References 935 Chapter 15 Anomalies and Market Efficiency G. WILLIAM SCHWERT 939 Abstract 941 Keywords Introduction Selected empirical regularities Predictable differences in returns across assets Predictable differences in returns through time Returns to different types of investors ' Individual investors 95o 3.2. Institutional investors 95 o 3.3. Limits to arbitrage Long-run returns Returns to firms issuing equity Returns to bidder firms Implications for asset pricing The search for risk factors Conditional asset pricing Excess volatility The role of behavioral finance Implications for corporate finance Firm size and liquidity Book-to-market effects Slow reaction to corporate financial policy Conclusions 970 References 970 Chapter 16 Are Financial Assets Priced Locally or Globally? G. ANDREW KAROLYI and RENE M. STULZ 975 Abstract 976 Keywords Introduction The perfect financial markets model Identical consumption-opportunity sets across countries 979

6 xxii Contents of Volume IB 2.2. Different consumption-opportunity sets across countries A general approach Empirical evidence on asset pricing using perfect market models Home bias Flows, spillovers, and contagion Flows and returns Correlations, spillovers, and contagion Conclusion 1014 References 1014 Chapter 17 Microstructure and Asset Pricing DAVID EASLEY and MAUREEN O'HARA 1021 Abstract 1022 Keywords Introduction Equilibrium asset pricing Asset pricing in the short-run The mechanics of pricing behavior The adjustment of prices to information Statistical and structural models of microstructure data Volume and price movements Asset pricing in the long-run Liquidity 1036 \ 4.2. Information Linking microstructure and asset pricing: puzzles for researchers 1044 References 1047 Chapter 18 A Survey of Behavioral Finance NICHOLAS BARBERIS and RICHARD THALER 1053 Abstract 1054 Keywords Introduction Limits to arbitrage Market efficiency Theory Evidence *. Psychology Beliefs Preferences Application: The aggregate stock market The equity premium puzzle 1078

7 Contents of Volume IB xxiii 4.2. The volatility puzzle Application: The cross-section of average returns Belief-based models Belief-based models with institutional frictions Preferences 1U"/ 6. Application: Closed-end funds and comovement Closed-end funds Comovement luyy 7. Application: Investor behavior Insufficient diversification Naive diversification Excessive trading The selling decision The buying decision Application: Corporate finance Security issuance, capital structure and investment " Dividends H Models of managerial irrationality Conclusion 1113 Appendix A 1115 References M16 Finance, Optimization, and the Irreducibly Irrational Component of Human Behavior ROBERT J. SHILLER 1125 Chapter 19 Derivatives ROBERT E. WHALEY 1129 Abstract 1131 Keywords " Introduction Background No-arbitrage pricing relations Carrying costs Valuing forward/futures using the no-arbitrage principle Valuing options using the no-arbitrage principle Option valuation The Black-Scholes/Merton option valuation theory Analytical formulas H Approximation methods Generalizations 1164

8 xxiv Contents of Volume IB 5. Studies of no-arbitrage price relations Forward/futures prices Option prices Summary and analysis Studies of option valuation models Pricing errors/implied volatility anomalies Trading simulations Informational content of implied volatility Summary and analysis Social costs/benefits of derivatives trading Contract introductions Contract expirations Market synchronization Summary and analysis Summary ' 1198 References 1199 Chapter 20 Fixed-Income Pricing QIANG DAI and KENNETH J. SINGLETON 1207 Abstract 1208 Keywords Introduction Fixed-income pricing in a diffusion setting The term structure Fixed-income securities with deterministic payoffs Fixed-income securities with state-dependent payoffs Fixed-income securities with stopping times Dynamic term-structure models for default-free bonds One-factor dynamic term-structure models Multi-factor dynamic term-structure models Dynamic term-structure models with jump diffusions Dynamic term-structure models with regime shifts Dynamic term-structure models with rating migrations Fractional recovery of market value Fractional recovery of par, payable at maturity Fractional recovery of par, payable at default Pricing defaultable coupon bonds 1229 ' 6.5. Pricing Eurodollar swaps Pricing of fixed-income derivatives Derivatives pricing using dynamic term-structure models Derivatives pricing using forward-rate models Defaultable forward-rate models with rating migrations 1234

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