CONTENTS OF VOLUME IB

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 606 1. Introduction 607 2. Portfolio problems 607 3. Absence of arbitrage and preference-free results 612 3.1. Fundamental theorem of asset pricing "14 3.2. Pricing rule representation theorem 616 4. Various analyses: Arrow-Debreu world 618 4.1. Optimal portfolio choice 619 4.2. Efficient portfolios 619 4.3. Aggregation 620 4.4. Asset pricing 621 4.5. Payoff distribution pricing 622 5. Capital asset pricing model (CAPM) 624 6. Mutual fund separation theory 629 6.1. Preference approach 629 6.2. Beliefs 631 7. Arbitrage pricing theory (APT) 633 8. Conclusion 634 References 634 Chapter 11 Intertemporal Asset Pricing Theory DARRELL DUFFIE 639 Abstract 641

xviii Contents of Volume IB Keywords, 641 1. Introduction 642 2. Basic theory - 642 2.1. Setup 643 2.2. Arbitrage, state prices, and martingales 644 2.3. Individual agent optimality 646 2.4. Habit and recursive utilities 647 2.5. Equilibrium and Pareto optimality 649 2.6. Equilibrium asset pricing 651 2.7. Breeden's consumption-based CAPM 653 2.8. Arbitrage and martingale measures 654 2.9. Valuation of redundant securities 656 2.10. American exercise policies and valuation 657 3. Continuous-time modeling 661 3.1. Trading gains for Brownian prices ' 662 3.2. Martingale trading gains 663 3.3. The Black-Scholes option-pricing fonnula 665 3.4. Ito's Formula 668 3.5. Arbitrage modeling 670 3.6. Numeraire invariance. 670 3.7. State prices and doubling strategies 671 3.8. Equivalent martingale measures 672 3.9. Girsanov and market prices of risk 672 3.10. Black-Scholes again 676 \ 3.11. Complete markets 677 3.12. Optimal trading and consumption 678 3.13. Martingale solution to Merton's problem 682 4. Term-structure models 686 4.1. One-factor models 687 4.2. Term-structure derivatives 691 4.3. Fundamental solution 693 4.4. Multifactor term-structure models 695 4.5. Affine models 696 4.6. The HJM model of forward rates 699 5. Derivative pricing 702 5.1. Forward and futures prices 702 5.2. Options and stochastic volatility 705 5.3. Option valuation by transform analysis 708 6. i Corporate securities 711 6.1. Endogenous default timing 712 6.2. Example: Brownian dividend growth 713 6.3. Taxes, bankruptcy costs, capital structure 717 6.4. Intensity-based modeling of default 719

Contents of Volume IB xix 6.5. Zero-recovery bond pricing 721 6.6. Pricing with recovery at default 722 6.7. 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 745 1. Introduction 746 2. Multifactor asset-pricing models: Review and integration 748 2.1. The stochastic discount factor representation 748 2.2. Expected risk premiums 750 2.3. Return predictability 751 2.4. Consumption-based asset-pricing models 753 2.5. Multi-beta pricing models 754 2.6. Mean-variance efficiency with conditioning information 760 2.7. Choosing the factors 765 3. Modern variance bounds 768 3.1. The Hansen-Jagannathan bounds 768 3.2. Variance bounds with conditioning information 770 3.3. The Hansen-Jagannathan distance 773 4. Methodology and tests of multifactor asset-pricing models 774 4.1. The Generalized Method of Moments approach 774 4.2. Cross-sectional regression methods 775 4.3. Multivariate regression and beta-pricing models 781 5. Conditional performance evaluation 785 5.1. Stochastic discount factor formulation 787 5.2. Beta-pricing formulation 788 5.3. Using portfolio weights 790 5.4. Conditional market-timing models 792 5.5. Empirical evidence on conditional performance 793 6. Conclusions 794 References 795 Chapter 13 Consumption-Based Asset Pricing JOHN Y. CAMPBELL 803 Abstract 804 Keywords 804 1. Introduction 805

xx Contents of Volume IB 2. International stock market data 810 3. The equity premium puzzle 816 3.1. The stochastic discount factor " 816 3.2. Consumption-based asset pricing with power utility 819 3.3. The risk-free rate puzzle 824 3.4. Bond returns and the equity-premium and risk-free rate puzzles 827 3.5. Separating risk aversion and intertemporal substitution 828 4. The dynamics of asset returns and consumption 832 4.1. Time-variation in conditional expectations 832 4.2. A loglinear asset-pricing framework 836 4.3. The equity volatility puzzle 840 4.4. Implications for the equity premium puzzle 845 4.5. What does the stock market forecast? 849 4.6. Changing volatility in stock returns 857 4.7. What does the bond market forecast? ' 859 5. Cyclical variation in the price of risk 866 5.1. Habit formation 866 5.2. Models with heterogeneous agents 873 5.3. Irrational expectations 876 6. Some implications for macroeconomics 879 References ' 881 Chapter 14 The Equity Premium in Retrospect ^RAJNISH MEHRA and EDWARD C. PRESCOTT 889 Abstract 890 Keywords 890 1. Introduction 891 2. The equity premium: history 891 2.1. Facts 891 2.2. Data sources 892 2.3. Estimates of the equity premium 894 2.4. Variation in the equity premium over time 897 3. Is the equity premium due to a premium for bearing non-diversifiable risk? 899 3.1. Standard preferences 902 3.2. Estimating the equity risk premium versus estimating the risk aversion parameter 912 3.3. Alternative preference structures 913 3.4. Idiosyncratic and uninsurable income risk 918 '3.5. Models incorporating a disaster state and survivorship bias 920 4. Is the equity premium due to borrowing constraints, a liquidity premium or taxes? 921 4.1. Borrowing constraints 921 4.2. Liquidity premium 924

Contents of Volume IB xxl 4.3. Taxes and regulation 924 5. 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 941 1. Introduction 942 2. Selected empirical regularities 943 2.1. Predictable differences in returns across assets 943 2.2. Predictable differences in returns through time 951 3. Returns to different types of investors ' 956 3.1. Individual investors 95o 3.2. Institutional investors 95 o 3.3. Limits to arbitrage 961 4. Long-run returns 961 4.1. Returns to firms issuing equity 962 4.2. Returns to bidder firms 964 5. Implications for asset pricing 966 5.1. The search for risk factors 966 5.2. Conditional asset pricing 967 5.3. Excess volatility 967 5.4. The role of behavioral finance 967 6. Implications for corporate finance 968 6.1. Firm size and liquidity 968 6.2. Book-to-market effects 968 6.3. Slow reaction to corporate financial policy 969 7. Conclusions 970 References 970 Chapter 16 Are Financial Assets Priced Locally or Globally? G. ANDREW KAROLYI and RENE M. STULZ 975 Abstract 976 Keywords 976 1. Introduction 977 2. The perfect financial markets model 978 2.1. Identical consumption-opportunity sets across countries 979

xxii Contents of Volume IB 2.2. Different consumption-opportunity sets across countries 982 2.3. A general approach 988 2.4. Empirical evidence on asset pricing using perfect market models 992 3. Home bias 997 4. Flows, spillovers, and contagion 1004 4.1. Flows and returns 1007 4.2. Correlations, spillovers, and contagion 1010 5. Conclusion 1014 References 1014 Chapter 17 Microstructure and Asset Pricing DAVID EASLEY and MAUREEN O'HARA 1021 Abstract 1022 Keywords 1022 1. Introduction 1023 2. Equilibrium asset pricing 1024 3. Asset pricing in the short-run 1025 3.1. The mechanics of pricing behavior 1026 3.2. The adjustment of prices to information 1029 3.3. Statistical and structural models of microstructure data 1031 3.4. Volume and price movements 1033 4. Asset pricing in the long-run 1035 4.1. Liquidity 1036 \ 4.2. Information 1041 5. 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 1054 1. Introduction 1055 2. Limits to arbitrage 1056 2.1. Market efficiency 1056 2.2. Theory 1058 2.3. Evidence 1061 3*. Psychology 1065 3.1. Beliefs 1065 3.2. Preferences 1069 4. Application: The aggregate stock market 1075 4.1. The equity premium puzzle 1078

Contents of Volume IB xxiii 4.2. The volatility puzzle 1083 5. Application: The cross-section of average returns 1087 5.1. Belief-based models 1092 5.2. Belief-based models with institutional frictions 1095 5.3. Preferences 1U"/ 6. Application: Closed-end funds and comovement 1098 6.1. Closed-end funds 1098 6.2. Comovement luyy 7. Application: Investor behavior 1101 7.1. Insufficient diversification 1101 7.2. Naive diversification 1103 7.3. Excessive trading 1103 7.4. The selling decision 1104 7.5. The buying decision 1105 8. Application: Corporate finance 1106 8.1. Security issuance, capital structure and investment "1106 8.2. Dividends H09 8.3. Models of managerial irrationality 1111 9. 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 " 1131 1. Introduction 1132 2. Background 1133 3. No-arbitrage pricing relations 1139 3.1. Carrying costs 1140 3.2. Valuing forward/futures using the no-arbitrage principle 1141 3.3. Valuing options using the no-arbitrage principle 1143 4. Option valuation 1148 4.1. The Black-Scholes/Merton option valuation theory 1149 4.2. Analytical formulas H51 4.3. Approximation methods 1157 4.4. Generalizations 1164

xxiv Contents of Volume IB 5. Studies of no-arbitrage price relations 1166 5.1. Forward/futures prices 1167 5.2. Option prices 1169 5.3. Summary and analysis 1173 6. Studies of option valuation models 1173 6.1. Pricing errors/implied volatility anomalies 1174 6.2. Trading simulations 1176 6.3. Informational content of implied volatility 1179 6.4. Summary and analysis 1181 7. Social costs/benefits of derivatives trading 1189 7.1. Contract introductions 1189 7.2. Contract expirations 1193 7.3. Market synchronization 1194 7.4. Summary and analysis 1197 8. Summary ' 1198 References 1199 Chapter 20 Fixed-Income Pricing QIANG DAI and KENNETH J. SINGLETON 1207 Abstract 1208 Keywords 1208 1. Introduction 1209 2. Fixed-income pricing in a diffusion setting 1210 2.1. The term structure 1210 2.2. Fixed-income securities with deterministic payoffs 1211 2.3. Fixed-income securities with state-dependent payoffs 1212 2.4. Fixed-income securities with stopping times 1213 3. Dynamic term-structure models for default-free bonds 1215 3.1. One-factor dynamic term-structure models 1215 3.2. Multi-factor dynamic term-structure models 1218 4. Dynamic term-structure models with jump diffusions 1222 5. Dynamic term-structure models with regime shifts 1223 6. Dynamic term-structure models with rating migrations 1225 6.1. Fractional recovery of market value 1225 6.2. Fractional recovery of par, payable at maturity 1228 6.3. Fractional recovery of par, payable at default 1229 6.4. Pricing defaultable coupon bonds 1229 ' 6.5. Pricing Eurodollar swaps 1230 7. Pricing of fixed-income derivatives 1231 7.1. Derivatives pricing using dynamic term-structure models 1231 7.2. Derivatives pricing using forward-rate models 1232 7.3. Defaultable forward-rate models with rating migrations 1234