Microfoundations of Financial Economics

Microfoundations of Financial Economics: An Introduction to General Equilibrium Asset Pricing

Yvan Lengwiler
Copyright Date: April 2006
Pages: 304
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  • Book Info
    Microfoundations of Financial Economics
    Book Description:

    This textbook takes the reader from the level of microeconomics principles through to modern asset pricing theory. Yvan Lengwiler elegantly links together issues that have in the past been the territory of general economic theorists on the one hand, and financial economists on the other.

    In a sequence of carefully explained steps, the reader learns how the first welfare theorem is used in asset pricing theory. The book then moves on to explore Radner economies and von Neumann-Morgenstern decision theory, and this section culminates in Wilson's mutuality principle and the consumption-based CAPM. This is then put into a dynamic setting, and term structure models are introduced. The empirical shortcomings of the standard asset pricing models are extensively discussed, as is research from the last twenty years aimed at bringing theory in line with reality. The reader is brought up to date on the latest areas of concern, such as habit formation, the consequences of heterogeneity, demographic effects, changing tax regimes, market frictions, and the implications of prospect theory for asset pricing.

    Aimed at masters or Ph.D. students specializing in financial economics, the book can also be used as a supplementary text for students of macroeconomics at this advanced level and will be of interest to finance professionals with a background in economics and mathematics. It includes problems (with solutions), and an accompanying website provides supporting material for lecturers.

    eISBN: 978-1-4008-2957-6
    Subjects: Economics, Finance

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-x)
  3. List of boxes
    (pp. xi-xii)
  4. Preface
    (pp. xiii-xvi)
  5. 1 Introduction
    (pp. 1-9)

    How much should you save? and How much risk should you bear? When we think about these questions, it becomes clear pretty quickly that they are of great importance to our overall material well-being. Saving is essential because most of us will retire at some point. From that point onwards, although we will still be consuming, we will receive no more labor income. Moreover, we will all face significant economic risks during our lives—the risk of losing our job, for instance, or—much worse—of becoming unable to work because of illness or other misfortunes. Clearly, the risks we...

  6. 2 Contingent claim economy
    (pp. 10-36)

    Economists use the word commodity in a very precise way. Their definition of a commodity may seem peculiar to the non-initiated, but it is a powerful notion that is very helpful for thinking about economic problems. So we will begin this introductory chapter with a discussion of this important concept. After that we move on to the notion of a general equilibrium of a contingent claim economy. This, too, is a fundamental notion. At the same time, it is, in a way, the most simple and the most abstract representation of a complex economy. It is essential to have a...

  7. 3 Asset economy
    (pp. 37-67)

    The trading arrangements we have studied so far bear little resemblance to our practical everyday experience. Many contingent claims markets do not exist. For instance, there is no market for bananas next Christmas provided it rains. What we see, roughly, is a set of spot markets combined with a set of financial markets. This chapter is about how to solve our individuals’ decision problems facing these more involved markets, and how to reformulate our notion of a general equilibrium. We will also learn how the notion of a complete financial market allows us to work with a representative commodity.


  8. 4 Risky decisions
    (pp. 68-101)

    In chapter 2 we defined commodities to be contingent upon events or states. This framework provides us with a powerful tool for thinking and theorizing about decisions under risk. In fact, within the theory we have been using so far, decisions that concern risky outcomes are formally identical to decisions concerning the time or the place that some commodity will be available, or its physical characteristics. In other words, choosing whether to buy health insurance is formally the same as the decision to buy a vacation in Hawaii or a new car.

    Yet, decisions about risk exposure have a special...

  9. 5 Static finance economy
    (pp. 102-140)

    This is the key theory chapter of this book. We now combine the Arrow–Debreu–Radner economy of chapters 2 and 3 with the von Neumann–Morgenstern utility of chapter 4. The payoff of this combination is considerable. We will be able to obtain much more concrete asset pricing formulas with more interpretations and content, and more empirically testable relationships. This marriage of general equilibrium theory and NM utility theory is a cornerstone of modern asset pricing theory. This is why we call the structure a finance economy.

    But the finance economy is not only the playground of modern asset...

  10. 6 Dynamic finance economy
    (pp. 141-171)

    The model of the previous chapter is simplified in that it assumes that there are only two periods. Of course we could interpret these “periods” as present and future, but then the model does not allow us to think about the effects of the gradual resolution of uncertainty. Also, it is not necessarily natural to assume a finite horizon.¹ Luckily, the model generalizes to many periods, thereby increasing the realism and scope considerably. However, moving to an infinite horizon opens up some technical difficulties which require special consideration.

    The first step in generalizing the model to accommodate many periods is...

  11. 7 Empirics and the puzzles
    (pp. 172-198)

    The time has come to confront the empirical evidence. In this chapter you will be told that the theory you have learned so far fails miserably when confronted with the data! The empirical failure of the model, whose most famous incarnation is the equity premium puzzle, was a great disappointment for the profession. But of course, scientists are not inclined to give up when an intellectual puzzle emerges. In hindsight, the puzzles have generated a rich research effort that has produced many new and interesting ideas.

    An asset is free of risk if the cash flow it delivers in the...

  12. 8 Adapting the theory
    (pp. 199-238)

    Even though the asset pricing puzzles are, by their very nature, negative results, they have been seminal in the sense of launching an intensive search for their resolution. We discussed one branch of this research in the last chapter. This entails regarding the puzzle as misinterpretation the data. One can claim that the arguments put forth by these researchers justify a significantly reduced estimate of the equity premium, from more than 6% to about 2%. But 2% is still too much, so a puzzle remains, at least for the data up to about 1980. Since then the forward looking premium...

  13. 9 Epilog
    (pp. 239-244)

    The gross empirical failure of the CCAPM that was most visibly identified by Mehra & Prescott (1985) was a shock to the profession. This failure has potentially serious consequences, not only for finance, but for macroeconomics as a whole, because much of modern macroeconomics is built on basically the same model that underlies the CCAPM: the stochastic competitive general equilibrium of an economy populated by a representative von Neumann–Morgenstern expected utility maximizer. So, if the CCAPM is to be discarded, much of macroeconomic theory will go with it. This is clearly true for real business cycle theory, which was...

  14. Appendix A Symbols and notation
    (pp. 245-246)
  15. Appendix B Solutions to the problem sets
    (pp. 247-268)
  16. Bibliography
    (pp. 269-284)
  17. Index
    (pp. 285-287)