Contents
List of figures viii
List of numbered boxes x
List of tables xii
1 Introduction 1
1.1 Chapter summaries 3
1.2 Concluding remarks 12
2 Investment decisions under certainty 14
2.1 Intertemporal consumption in autarky 16
2.1.1 Endowments without storage 16
2.1.2 Endowments with storage 18
2.1.3 Other private investment opportunities 20
2.2 Intertemporal consumption in a market economy 22
2.2.1 Endowments with atemporal trade 22
2.2.2 Endowments with atemporal trade and fiat money 23
2.2.3 Endowments with full trade 25
2.2.4 Asset economy with private investment opportunities 31
2.2.5 Asset economy with investment by firms 34
2.2.6 Asset economy with investment by firms and fiat money 37
2.3 Asset prices and inflation 40
2.3.1 The Fisher effect 41
2.3.2 Wealth effects in the money market 44
2.4 Valuing financial assets 48
2.4.1 Term structure of interest rates 49
2.4.2 Fundamental equation of yield 52
2.4.3 Convenient pricing models 54
2.4.4 Compound interest 55
2.4.5 Bond prices 57
2.4.6 Share prices 58
2.4.7 Price–earnings ratios 60
2.4.8 Firm valuations and the cost of capital 63
Problems 65
3 Uncertainty and risk 71
3.1 State-preference theory 73
3.1.1 The (finite) state space 73
3.1.2 Debreu economy with contingent claims 75
3.1.3 Arrow–Debreu asset economy 77
3.2 Consumer preferences 83
3.2.1 Von Neumann–Morgenstern expected utility 86
3.2.2 Measuring risk aversion 87
3.2.3 Mean–variance preferences 89
3.2.4 Martingale prices 90
3.3 Asset pricing in a two-period setting 92
3.3.1 Asset prices with expected utility 92
3.3.2 The mutuality principle 96
3.3.3 Asset prices with mean–variance preferences 101
3.4 Term structure of interest rates 103
Problems 105
4 Asset pricing models 107
4.1 Capital asset pricing model 109
4.1.1 Consumption space and preferences 109
4.1.2 Financial investment opportunity set 111
4.1.3 Security market line – the CAPM equation 122
4.1.4 Relaxing the assumptions in the CAPM 125
4.2 Arbitrage pricing theory 129
4.2.1 No arbitrage condition 131
4.3 Consumption-based pricing models 133
4.3.1 Capital asset pricing model 134
4.3.2 Intertemporal capital asset pricing model 136
4.3.3 Arbitrage pricing theory 137
4.3.4 Consumption-beta capital asset pricing model 139
4.4 A comparison of the consumption-based pricing models 142
4.5 Empirical tests of the consumption-based pricing models 143
4.5.1 Empirical tests and the Roll critique 144
4.5.2 Asset pricing puzzles 145
4.5.3 Explanations for the asset pricing puzzles 147
4.6 Present value calculations with risky discount factors 151
4.6.1 Different consumption risk in the revenues and costs 151
4.6.2 Net cash flows over multiple time periods 153
Problems 157
5 Private insurance with asymmetric information 161
5.1 Insurance with common information 163
5.1.1 No administrative costs 163
5.1.2 Trading costs 167
5.2 Insurance with asymmetric information 169
5.2.1 Moral hazard 169
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