Handbook of the Economics of Finance, Volume 2B: Asset Pricing Volume 2B

The 12 articles in this second of two parts condense recent advances on investment vehicles, performance measurement and evaluation, and risk management into a coherent springboard for future research. Written by world leaders in asset pricing research, they present scholarship about the 2008 financial crisis in contexts that highlight both continuity and divergence in research. For those who seek authoritative perspectives and important details, this volume shows how the boundaries of asset pricing have expanded and at the same time have grown sharper and more inclusive. Offers analyses by top scholars of recent asset pricing scholarshipExplains how the 2008 financial crises affected theoretical and empirical researchCovers core and newly-developing fields.Handbook of the Economics of Finance - Volume 2B ONLY: Asset Pricing by George Constantinides, Milton Harris, Rene StulzPlease note that this Volume 2B has no front cover and looks likethe original two volume book was ripped in half and this resulted.For Volume 2A see: the full book containing BOTH volumes see: 12 Advances in Consumption-Based Asset Pricing: Empirical Tests*......Page 1 1.Introduction......Page 2 2. Consumption-Based Models: Notation and Background......Page 5 3.1 GMM Review (Hansen, 1982)......Page 8 3.2 A Classic Asset Pricing Application: Hansen and Singleton (1982)......Page 9 3.3.1 Comparing Specification Error: Hansen and Jagannathan (1997)......Page 12 3.3.2 Statistical Comparison of HJ Distance......Page 14 3.3.3 Reasons to Use (and Not to Use) Identity Weighting......Page 15 4. Euler Equation Errors and Consumption-Based Models......Page 17 5. Scaled Consumption-Based Models......Page 21 5.1 Econometric Findings......Page 25 5.2 Distinguishing Two Types of Conditioning......Page 26 5.3 Debate......Page 31 6. Asset Pricing with Recursive Preferences......Page 40 6.1 EZW Recursive Preferences......Page 42 6.2 EZW Preferences with Unrestricted Dynamics: Distribution-Free Estimation......Page 44 6.2.1 Two-Step Procedure......Page 48 6.2.2 First Step......Page 49 6.2.3 Second Step......Page 50 6.2.4 Econometric Findings......Page 51 6.3 EZW Preferences with Restricted Dynamics: Long-Run Risk......Page 53 6.3.1 Econometric Findings on Long-Run Risk......Page 59 6.4 Debate......Page 69 7. Stochastic Consumption Volatility......Page 74 8. Asset Pricing with Habits......Page 83 8.1 Structural Estimation of Campbell–Cochrane Habit......Page 85 8.2 Flexible Estimation of Habit Preferences with Unrestricted Dynamics......Page 86 8.3 Econometric Findings......Page 89 8.4 Debate......Page 91 9. Asset Pricing with Heterogeneous Consumers and Limited Stock Market Participation......Page 92 10. Conclusion......Page 99 References......Page 102 13 Bond Pricing and the Macroeconomy......Page 109 1. Introduction......Page 110 2.1 A Bare-Bones Framework......Page 111 2.2 Implications and Alternatives......Page 113 2.3 What are the Factors?......Page 114 2.4 Taylor Rule Stories......Page 115 3.1 Stochastic Discount Factors......Page 117 3.2 Bond Pricing......Page 120 3.3 Implications of No-Arbitrage Restrictions......Page 121 4.1 Macroeconomic Data......Page 123 4.2 Spanning......Page 125 4.3 A Workhorse Empirical Example......Page 130 4.4 Interpreting and Altering Cross-Sectional Accuracy......Page 133 5.1 Practical Approaches to Modeling Risk Premia......Page 135 5.2 A Brief Example......Page 136 5.3 Some Properties of Observed Bond Returns......Page 139 5.4 Power Utility......Page 142 5.5 Recursive Utility......Page 144 5.6 The Empirical Performance of Power and Recursive Utility......Page 145 5.7 Predictable Variation of Excess Bond Returns......Page 150 5.8 Extensions to Power Utility and Recursive Utility......Page 154 5.9 Moving Away from Endogenous Risk Premia......Page 157 6.1 A Reduced-Form New Keynesian Model......Page 158 6.2 Nesting the Model in a General Factor Structure......Page 160 6.3 Adding Nominal Bonds......Page 162 6.4 An Empirical Application......Page 163 References......Page 167 14 Investment Performance: A Review and Synthesis......Page 170 1. Introduction......Page 171 2. The Stochastic Discount Factor (SDF) Framework......Page 172 2.1 Market Efficiency and Fund Performance......Page 173 2.2 The Treatment of Costs......Page 175 3.1 Returns-Based Alpha and Appropriate Benchmarks......Page 176 3.2 The Sharpe Ratio......Page 178 3.3 Conditional Performance Evaluation (CPE)......Page 179 3.3.1 Time-Varying Ability?......Page 181 3.4 Unconditional Efficiency and Performance Evaluation......Page 182 3.5 Market Timing......Page 183 3.7.1 The Foundations of Holdings-Based Measures......Page 185 3.7.2 Why Current Holdings-Based Measures are Flawed......Page 187 3.7.3 When are Current Holdings-Based Measures Justified?......Page 188 3.7.4 Combining Holdings and Returns......Page 189 4. Implementation Issues and Empirical Examples......Page 190 4.1 Data Issues......Page 191 4.2 Interim Trading......Page 192 4.3.1 The NAV Liquidity Option......Page 193 4.3.2 The Liquidity of Fund Assets......Page 194 4.3.3 Return Smoothing and Illiquidity......Page 195 4.4 Empirical Examples......Page 196 4.5 Skill Versus Luck......Page 200 5. Fund Managers’ Incentives and Investor Behavior......Page 201 5.1 Flows to Mutual Funds......Page 203 References......Page 205 15 Mutual Funds......Page 212 1. Introduction......Page 213 1.1 Open-End Mutual Funds......Page 215 1.3 Exchange-Traded Funds......Page 217 2.1.1 Data Sources, Data Problems, and Biases......Page 218 2.1.2 Performance Measurement of Index Funds......Page 220 2.1.2.2 Tracking Error......Page 221 2.1.2.4 Enhanced Return Index Funds......Page 222 2.1.3.1 Early Models of Performance Measurement......Page 223 2.1.3.2.1 Multi-Index Benchmarks Estimated Using Returns Data.......Page 225 2.1.3.2.2 Using Holdings Data to Measure Performance Directly.......Page 229 2.1.3.2.3 Time-Varying Betas.......Page 230 2.1.3.2.4 Conditional Models of Performance Measurement, Bayesian Analysis, and Stochastic Discount Factors.......Page 231 2.1.3.2.5 What’s a Researcher to Do?......Page 233 2.1.4 Measuring the Performance of Active Bond Funds......Page 234 2.1.5 Measuring Timing......Page 236 2.1.5.2 Holding Measures of Timing......Page 237 2.2 How Well Have Active Funds Done?......Page 239 2.3 How Well Do Investors Do in Selecting Funds?......Page 245 2.4 Other Characteristics of Good-Performing Funds......Page 246 2.5 What Affects Flows Into Funds?......Page 248 3. Closed-End Funds......Page 249 3.1 Explaining the Discount......Page 250 3.2 Why Closed-End Funds Exist......Page 252 4. Exchange-Traded Funds (ETFs)......Page 253 4.1 Tracking Error......Page 254 4.3 Performance Relative to Other Instruments......Page 255 4.4 Their Use of Price Formation......Page 256 4.5 The Effect of Leverage......Page 257 References......Page 258 1. The Hedge Fund Business Model—A Historical Perspective......Page 263 2.1 Were the Lofty Expectations of Early Hedge Fund Investors Fulfilled?......Page 269 2.2 The Arrival of Institutional Investors......Page 274 2.3 Hedge Fund Performance—The Post Dot-com Bubble Era......Page 276 2.4 Absolute Return and Alpha—A Rose by Any Other Name?......Page 277 3.1 From Passive Index Strategies to Active Hedge Fund Styles......Page 285 3.3 Return-Based Style Factors......Page 287 3.4 Top-Down Versus Bottom-Up Models of Hedge Fund Strategy Risk......Page 289 3.5 Directional Hedge Fund Styles: Trend Followers and Global Macro......Page 290 3.6 Event-Driven Hedge Fund Styles: Risk Arbitrage and Distressed......Page 293 3.7 Relative Value and Arbitrage-like Hedge Fund Styles: Fixed Income Arbitrage, Convertible Arbitrage, and Long/Short Equity......Page 296 3.8 Niche Strategies: Dedicated Short Bias, Emerging Market and Equity Market Neutral......Page 301 4.1 Portfolio Construction and Performance Trend......Page 303 4.1.1 How Much of the LHF27 Portfolio’s Monthly Alpha of 2.11% (1990–1993) and 0.92% (1994–1996) is Due to Measurement Bias?......Page 308 4.1.2 Simulating the Performance of Investing in Large Funds......Page 311 4.2 Risk Management and a Tale of Two Risks......Page 315 4.3 Alpha-Beta Separation, Replication Products, and Fees......Page 317 4.4 Concluding Remarks......Page 321 References......Page 324 17 Financial Risk Measurement for Financial Risk Management*......Page 326 1. Introduction......Page 327 1.1 Six Emergent Themes......Page 328 1.2 Conditional Risk Measures......Page 329 2. Conditional Portfolio-Level Risk Analysis......Page 332 2.1.1 Exponential Smoothing and RiskMetrics......Page 333 2.1.2 The GARCH(1,1) Model......Page 335 2.1.3 Extensions of the Basic GARCH Model......Page 338 2.2 Intraday Data and Realized Volatility......Page 341 2.2.1 Dynamic Modeling of Realized Volatility......Page 346 2.2.2 Realized Volatilities and Jumps......Page 350 2.2.3 Combining GARCH and RV......Page 353 2.3 Modeling Return Distributions......Page 355 2.3.1 Procedures Based on GARCH......Page 359 2.3.2 Procedures Based on Realized Volatility......Page 361 2.3.3 Combining GARCH and RV......Page 363 2.3.4 Simulation Methods......Page 364 2.3.5 Extreme Value Theory......Page 365 3. Conditional Asset-Level Risk Analysis......Page 366 3.1 Modeling Time-Varying Covariances Using Daily Data and GARCH......Page 367 3.1.1 Dynamic Conditional Correlation Models......Page 370 3.1.2 Factor Structures and Base Assets......Page 373 3.2 Intraday Data and Realized Covariances......Page 375 3.2.1 Regularizing Techniques for RCov Estimation......Page 378 3.2.2 Dynamic Modeling of Realized Covariance Matrices......Page 383 3.2.3 Combining GARCH and RCov......Page 387 3.3 Modeling Multivariate Return Distributions......Page 389 3.3.1 Multivariate Parametric Distributions......Page 390 3.3.2 Copula Methods......Page 391 3.3.3 Combining GARCH and RCov......Page 393 3.3.4 Multivariate Simulation Methods......Page 395 3.3.5 Multivariate Extreme Value Theory......Page 396 3.4.1 Marginal Expected Shortfall and Expected Capital Shortfall......Page 398 3.4.2 CoVaR and ΔCoVaR......Page 399 3.4.3 Network Perspectives......Page 400 4. Conditioning on Macroeconomic Fundamentals......Page 402 4.1 The Macroeconomy and Return Volatility......Page 403 4.2 The Macroeconomy and Fundamental Volatility......Page 404 4.4 Other Links......Page 406 4.5 Factors as Fundamentals......Page 408 5. Concluding Remarks......Page 410 References......Page 411 18 Bubbles, Financial Crises, and Systemic Risk *......Page 420 1. Introduction......Page 421 2. A Brief Historical Overview of Bubbles and Crises......Page 424 3. Bubbles......Page 428 3.1 Rational Bubbles without Frictions......Page 430 3.2 OLG Frictions and Market Incompleteness......Page 432 3.3 Informational Frictions......Page 435 3.4 Delegated Investment and Credit Bubbles......Page 437 3.5 Heterogeneous-Beliefs Bubbles......Page 438 3.6 Empirical Evidence on Bubbles......Page 441 3.7 Experimental Evidence on Bubbles......Page 442 4. Crises......Page 444 4.1 Counterparty/Bank Runs......Page 446 4.1.1 Bank Runs as a Sunspot Phenomenon......Page 447 4.1.2 Information-Induced Bank Runs......Page 449 4.2 Collateral/Margin Runs......Page 452 4.2.1 Loss Spiral......Page 453 4.2.2 Margin/Haircut or Leverage Spiral......Page 456 4.2.3 Contagion and Flight to Safety......Page 459 4.3 Lenders’ or Borrowers’ Friction?......Page 460 4.4 Network Externalities......Page 463 4.5 Feedback Effects Between Financial Sector Risk and Sovereign Risk......Page 467 5.1 Systemic Risk Measures......Page 470 5.2 Data Collection and Macro Modeling......Page 472 5.3 Challenges in Estimating Systemic Risk Measures......Page 474 5.4 Some Specific Measures of Systemic Risk......Page 476 6. Conclusion......Page 479 References......Page 480 1. Introduction......Page 488 2. Theory......Page 494 2.1 Perfect-Market Benchmark......Page 496 2.2 Participation Costs......Page 499 2.3 Transaction Costs......Page 503 2.4 Asymmetric Information......Page 508 2.5 Imperfect Competition......Page 513 2.6 Funding Constraints......Page 521 2.7 Search......Page 527 3. Empirical Evidence......Page 532 3.1 Empirical Measures of Illiquidity......Page 533 3.2 Properties of Illiquidity Measures......Page 540 3.3 Illiquidity and Asset Returns......Page 545 4. Conclusion......Page 550 References......Page 551 1. INTRODUCTION......Page 561 2. Risk-Neutral Default Probability Estimates......Page 562 2.1 The Risk-Free Rate......Page 566 3. Physical Default Probability Estimates......Page 567 3.1 Empirical Research on Default Probability Estimates......Page 568 3.2 Empirical Research on Credit Spreads......Page 571 4. Credit Default Swaps......Page 574 4.1 Credit Indices......Page 576 4.2 Fixed Coupons......Page 577 5.1 Cash CDOs......Page 578 5.2 Synthetic CDOs......Page 580 5.3 Synthetic CDO Valuation......Page 581 5.4 Default Correlation Models and the Probability of Default......Page 583 5.6 Gaussian and Other Factor Copula Models......Page 585 5.7 Index CDOs......Page 587 5.8 CDO Economics......Page 588 6. Credit Derivatives and the Crisis......Page 590 7. Conclusions......Page 592 References......Page 593 21 Household Finance: An Emerging Field*......Page 595 1. The Rise of Household Finance......Page 596 1.1 Why a New Field?......Page 597 1.2 Why Now?......Page 599 2. Facts About Household Assets and Liabilities......Page 600 2.1 Components of Lifetime Wealth: Human Capital......Page 601 2.2 Components of Lifetime Wealth: Tangible Assets......Page 604 2.2.2 The Wealth Allocation in Real and Financial Assets......Page 605 2.2.3 The Financial Portfolio......Page 611 2.3 Liabilities......Page 615 2.4 Trends......Page 617 2.5 Overall Reliance on Financial Markets......Page 618 2.6 International Comparisons......Page 619 3. Household Risk Preferences and Beliefs: What Do We Know?......Page 622 3.1.1 Revealed Preference Approach......Page 623 Qualitative Indicators......Page 626 Quantitative Measures......Page 628 3.2 Determinants of Risk Attitudes......Page 630 Revealed Preference Approach......Page 631 Elicitation of Risk Preferences......Page 634 Background Risk and Access to Credit Markets......Page 635 Demographics......Page 636 IQ and Personality......Page 637 Genetic Factors......Page 638 3.3 Time-Varying Risk Aversion?......Page 641 3.4 Heterogeneity in the Financial Wealth Elasticity of the Risky Share......Page 643 3.5 Ambiguity and Regret......Page 644 3.6 Beliefs......Page 647 3.7 Risk Aversion, Beliefs, and Financial Choices; Putting Merton’s Model to the Test......Page 648 4. Household Portfolio Decisions, from Normative Models to Observed Behavior......Page 650 4.1.1 Participation Costs and the Stockholding Puzzle......Page 651 4.1.2 Non-Standard Preferences and Limited Stock Market Participation......Page 652 4.1.3 Beliefs and Stock Market Participation......Page 654 4.1.4 Limited Participation in Other Financial Instruments......Page 656 4.2 Portfolio Selection......Page 657 4.2.1 Diversification......Page 658 4.2.2 Under-Diversification, Information, Hedging, and Preferences......Page 662 4.2.3 Frequency and Profitability of Trading......Page 668 4.2.4 Delegation of Portfolio Management and Financial Advice......Page 670 4.3 Portfolio Rebalancing in Response to Market Movements......Page 673 4.4 Portfolio Rebalancing Over the Life-Cycle......Page 676 4.4.1 Earlier Frictionless Models......Page 678 4.4.2 Non-Tradable and Non-Insurable Labor Income......Page 679 Too Large Share in Stocks when Young......Page 681 4.4.4 Welfare Implications......Page 683 Life-Cycle Patterns in Risk Aversion and Background Risk......Page 684 4.4.6 What Does the Empirical Evidence Tell Us About the Portfolio Life-Cycle?......Page 687 Some New Evidence......Page 688 5.2 Credit Availability......Page 694 5.3.1 Theories of Mortgage Choice......Page 697 5.3.2 Evidence on Mortgage Choice......Page 699 5.3.3 Repayment and Refinancing......Page 701 5.4 Defaulting on Mortgages......Page 703 5.4.1 A Basic Framework......Page 704 5.4.2 Evidence......Page 705 5.5 Credit Card Debt, Debate and Puzzles......Page 708 6. Conclusion......Page 710 References......Page 717 22 The Behavior of Individual Investors*......Page 731 1.1 The Average Individual......Page 733 1.1.1 Long-Horizon Results......Page 738 1.1.2 Short-Horizon Results......Page 740 1.1.3 Market vs. Limit Orders......Page 741 1.2 Cross-Sectional Variation in Performance......Page 742 2.2 Overconfidence......Page 745 2.3 Sensation Seeking......Page 747 2.4 Familiarity......Page 748 3.1 The Evidence......Page 749 3.2 Why do Investors Prefer to Sell Winners?......Page 755 5. Attention: Chasing the Action......Page 757 6. Failure to Diversify......Page 758 7. Are Individual Investors Contrarians?......Page 762 References......Page 763 23 Risk Pricing over Alternative Investment Horizons*......Page 769 1. Introduction......Page 770 2.1 Basic Setup......Page 771 2.2 A Convenient Factorization......Page 772 2.3 Other Familiar Changes in Measure......Page 774 2.4 Log-Linear Models......Page 775 2.5 Model-Based Factorizations......Page 776 2.5.2 Recursive Utility......Page 777 2.5.3 Altering Martingale Components......Page 779 2.6 Entropy Characterization......Page 780 3.1 Incorporating Stochastic Growth in the Cash Flows......Page 781 3.3 Shock Elasticities......Page 783 3.3.1 Lettau–Wachter Example......Page 786 3.3.2 Recursive Utility......Page 788 3.3.3 External Habit Models......Page 791 4. Market Restrictions......Page 792 4.1 Incomplete Contracting......Page 794 4.1.1 Trading Assets that Depend Only on Aggregate Shocks......Page 796 4.1.2 Efficient Allocations with Private Information......Page 797 4.2 Solvency Constraints......Page 800 4.3 Segmented Market and Nominal Shocks......Page 804 5. Conclusions......Page 805 References......Page 807 A......Page 810 C......Page 811 E......Page 815 F......Page 817 G......Page 818 H......Page 819 I......Page 821 K......Page 823 M......Page 824 N......Page 827 P......Page 828 R......Page 830 S......Page 832 T......Page 834 Y......Page 835 The 12 articles in this second of two parts condense recent advances on investment vehicles, performance measurement and evaluation, and risk management into a coherent springboard for future research. Written by world leaders in asset pricing research, they present scholarship about the 2008 financial crisis in contexts that highlight both continuity and divergence in research. For those who seek authoritative perspectives and important details, this volume shows how the boundaries of asset pricing have expanded and at the same time have grown sharper and more inclusive.

• Offers analyses by top scholars of recent asset pricing scholarship
• Explains how the 2008 financial crises affected theoretical and empirical research
• Covers core and newly developing fields

The 12 articles in this second of two parts condense recent advances on investment vehicles, performance measurement and evaluation, and risk management into a coherent springboard for future research. Written by world leaders in asset pricing research, they present scholarship about the 2008 financial crisis in contexts that highlight both continuity and divergence in research. For those who seek authoritative perspectives and important details, this volume shows how the boundaries of asset pricing have expanded and at the same time have grown sharper and more inclusive. Offers analyses by top scholars of recent asset pricing scholarship Explains how the 2008 financial crises affected theoretical and empirical research Covers core and newly developing fields