FE 8507 Lecture 2 More On Dynamic Security Markets Students

FE 8507 Stochastic Modelling in
Asset Pricing
Lecture 2
SDF, Arbitrage, Complete Markets and Portfolio
Choice
DR MANDY THAM
ATMTHAM@NTU. EDU. SG
NANYANG BUSI NESS SCHOOL
AY 2014-2015 MI NI -TERM 2
FE8507/DR MANDY THAM/2014_2015 1
Required
Read Chapter 8, Back
Read Lecture 2 notes
Revise Chapter 1 and 4, Back
Read The limits of arbitrage JF article.
Read the Forbes article
Tutorial 2

Learning Goals
SDF
Arbitrage and the law of one price
State prices and SDF
Risk-neutral probability
Complete markets
Portfolio choice in complete markets

2.1 More on SDF
Recall
1
(
+1
)
=
.(1)
If a risk-free security is not traded, then
in (1) is the shadow risk-free rate or

the zero-beta rate.
(1) is not particularly intuitive until we have replaced the unobservable SDF in terms
of some observables.
One way to do so is to choose the explicit form for the utility function.
Lets start with power utility (CRRA)

=
1
1
1
..(2)

2.1 More on SDF
Recall that
+1
= (
+1
..(3)
Now, show that
ln (
)= +
(

+1
)
1
2
(

+1
) .(4)

2.1 More on SDF: Lognormal distribution
A standard statistical result is that if X is lognormal, then
ln ~(
2
)

=
(
+
1
2
2
)
......(5)
where k = constant
e.g. ln ~(0.1, 0.25)
2 =
(20.1+
1
2
2
2
0.25)

2.1 Proof
ln ~(
2
)
=
(
+
1
2
2
)

ln =
+
1
2
2

Recall

+1
,+1
= 1
Let X =
+1
,+1
and conditional on info at time t, also
ln

+1
,+1
=
ln (
+1
,+1
) +
1
2
ln (
+1
,+1
) = 0
(ln (
+1
) +
(ln (
,+1
) +
1
2
ln (
+1
) +ln (
,+1
) = 0
(ln (
+1
) +
(ln (
,+1
) +
1
2
ln (
+1
+
1
2
(ln (
,+1
)+
ln
+1
, ln
,+1
= 0
...(6)

2.1 Proof
Now, let
,+1
=
(money market fund)
ln
= ln
ln
= 0
ln
+1
, ln
= 0
Using (5)
(ln (
+1
) +
(ln (
,+1
) +
1
2
ln (
+1
+
1
2
(ln (
,+1
)+
ln
+1
, ln
,+1
= 0
We have,
(ln (
+1
) +ln (
) +
1
2
ln (
+1
) = 0
Rearrange,
ln (
) =
(ln (
+1
)
1
2
ln (
+1
) .(7)

2.1 Proof
Next, take LN of (3)
ln
+1
= (
+1
(ln
+1
) =
(

+1
(ln
+1
=
2
(

+1
)
Finally, sub into (7)
ln (
) =
(ln (
+1
)
1
2
ln (
+1
)
= +
(

+1
)
1
2
(

+1
) ..(8) Q.E.D

2.1 Economic Intuition
Let us analyse (8)
ln (
) = +
(

+1
)
1
2
(

+1
+1
measures consumption growth,
is interest rate, measures patience and is called a subjective

discount factor.

1) Interest rate is high when expected consumption growth is high.
High interest rate is required to induce saving today in order to increase consumption tomorrow.

2) Interest rate is high when is low.
When people are impatient ( is low), a higher interest rate is required to induce savings.

FE8507/DR MANDY THAM/2014_2015 10
Let us analyse (8)
ln (
) = +
(

+1
)
1
2
(

+1
)

3) When consumption growth is expected to be volatile, interest rate is lower.
You lose more utility as consumption falls than you gain utility from an equal rise in
consumption. Naturally, you would want to hedge the greater fall in utility by saving more. This
is a form of precautionary savings.

4) When there is no risk aversion (=0), interest rate depends only on the subjective discount
factor (i.e. patience).

FE8507/DR MANDY THAM/2014_2015 11
Let us analyse (8)
ln (
) = +
(

+1
)
1
2
(

+1
)

5) As risk aversion () increases, interest rate becomes more responsive to expected
consumption growth.
Less willing to deviate from a smooth consumption across time

Eqn (8) indicates correlations and not causality between the LHS and RHS variables.
Conversely, we can interpret our correlations in opposite directions.

FE8507/DR MANDY THAM/2014_2015 12
2.1 Economic intuition
Let us analyse (8)
ln (
) = +
(

+1
)
1
2
(

+1
)
Example:
> 1 (more risk-averse than a log-utility with = 1), a higher interest rate raises second period
consumption more than one-to-one. Substitution effects dominate income effect.
Substitution effects => to switch from current consumption to savings.
Income effects=> higher income as real interest rate increases.
0 < < 1 (less risk-averse than a log-utility with = 1), a higher interest rate raises second
period consumption less than one-to-one. Income effects dominate substitution effect.
= 1 (log-utility), a higher interest rate raises second period consumption one-to-one.
Substitution effects equal income effect.

FE8507/DR MANDY THAM/2014_2015 13
2.1 Further remarks
from (8) ln (
) = +
(

+1
)
1
2
(

+1
)
Cross-refer to Week 1- Reading Pennacchi Pg 3
ln (
) = +(1
)

+1
(Pennacchi)
Pennacchi define
=
1
.
To reconcile our predictions (1)-(5) based on (8) with Pennacchi, let
= 1
Pennacchi also assumes that
+1
is non-stochastic, therefore

+1
= 0 and

+1
=

+1

We should use (8) which is the generic case assuming
+1
is stochastic.

FE8507/DR MANDY THAM/2014_2015 14
2.1 Further remarks
FE8507/DR MANDY THAM/2014_2015 15
In previous analysis, we assume returns and prices are given are in real terms.

+1
,+1
=
,
where
,+1
is the real payoff of asset i at time t+1
Suppose they are given in nominal terms, we must deflate by the consumer price index (CPI) at
time t.

+1

,+1
+1
=

,
+1
+1

,+1
,
= 1

+1
,+1
= 1 ...(9)
Where
+1
=

+1
+1

2.2 Hansen-Jagannathan Bounds
FE8507/DR MANDY THAM/2014_2015 16
Using

+1
,+1
= 1

+1
,
,+1
+

+1
)
(
,+1
= 1
Divide by

+1
,

+1
,
,+1

+1
+

,+1
=
1

+1

,+1
=

+1
,
,+1

(
+1
)
((
,+1
)

,+1

((
,+1
)
=

+1
,
,+1

(
+1
..(10a)
Since 1

+1
,
,+1
1,
|

,+

(
,+
)
|

+
=
+

.(10b) where
=1+

(10b) gives us the Hansen-Jagannathan bounds

FE8507/DR MANDY THAM/2014_2015 17
Sharpe ratio =

,+1

(
,+1
)

Empirical test: The Sharpe ratio of any portfolio/assets should not exceed

+
.

Using the same power utility previously,
+1
= (
+1

+
=

2
((
+1
((
+1
)
=

+1
)
2
(
+1
)
2
(

+1
)
=

+1
2
(

+1
)
2
1

FE8507/DR MANDY THAM/2014_2015 18
Assume ln
+1
/
~(
2
),
+1
) =
+
1
2

2

ln
/
0
~(
, (
1
2
)
2
2
),
+1
)
2
=
2
+2
2
+1
+
1
2

+
=

+1
2
(

+1
)
2
1 =

2
+2
2
+
2
2
1 =
2
1

= 1 +
2
2
+ 1
.(11) (Hint: use Taylors expansion)

2.3 CAPM
Key assumption of CAPM:
(
+
) =
,,+
where k>0

(
+1
),
,+1
= k
,+1
,
,+1
=
,+1

(
+1
),
,+1
=
,+1
,
,+1

Using
+1
,+1
= 1 (note: This gives the expected return of an asset in equilibrium.)

+1
) (
,+1
+(
+1
,
,+1
) = 1

,+1
=
1

+1

+1
,
,+1

+1

FE8507/DR MANDY THAM/2014_2015 19
2.3 CAPM
Since
+1
=
(
+1
)
)
,

,+1

(
+1
),
,+1

(
+1
)
=

,+1

(
+1
)
(a)

,+1

(
+1
),
,+1

(
+1
)
=

,,+1
,
,+1

(
+1
)
(b)
(b)/(a) and rearrange,

,+1

=

,+1
,
,+1

,+1
[
,+1

]

,+
=
[
,+

] .(12)

=

,+1
,
,+1

,+1
and
,+1

>0

FE8507/DR MANDY THAM/2014_2015 20
2.3 CAPM
Note:
= 1
(12) is CAPM and is also known as the Security Market line (SML).
Alpha is actual return minus expected return estimated from an APM such as
CAPM.
CAPM is an equilibrium model because it is derived from
+1
,+1
= 1
which is an equilibrium pricing model.
Equilibrium => no mispricing => zero alpha
=>

,+1

,
( ) =

,+1

,
=
,+1

FE8507/DR MANDY THAM/2014_2015 21
2.3 Testing CAPM
:
,+1
=
[
,+1

]
Test (1):
,+1

>0
Test (2): alpha =0
Empirically, CAPM fits the data badly.
Rethink how to specify our SDF ?
Rolls critique
CAPM is untestable.
Joint test:
(1) Empirical market proxy is correct.
(2) CAPM is correct.

FE8507/DR MANDY THAM/2014_2015 22
2.3 CAPM and Hansen-Jagannathan
Bounds

,+1

(
,+1
)
=

+1
,
,+1

+1
..(10a)

Under CAPM,
+1
,
,+1
= 1

,+1

(
,+1
)
=
(
+1

From (10a), we conclude |

,+

(
,+
)
|

+
=

,+1

(
,+1
)

CAPM specifies an upper limit, namely that any other assets cannot have an
absolute Sharpe ratio larger than that of the market portfolio.

FE8507/DR MANDY THAM/2014_2015 23
2.4 Arbitrage and the law of one price
An arbitrage opportunity for a finite T horizon is a self-financing wealth
process such that either

(i)
0
< 0 and
0 with probability 1 or

(i)
0
= 0 and
0 with probability 1 and
> 0 with positive

probability
Cross-reference Chapter 4.
FE8507/DR MANDY THAM/2014_2015 24
(i)
0
< 0 and
0 with probability 1
A third party sponsored your gamble, and your gamble paid off with no losses for
sure.

(ii)
0
= 0 and
0 with probability 1 and
> 0 with positive

probability
Zero initial investment in the portfolio but the portfolio sometimes pays off with
positive profit but never with losses.
A special case of arbitrage is when this zero-net investment portfolio produces a
riskless return.
FE8507/DR MANDY THAM/2014_2015 25
Example: Arbitrage
Opportunity
7-26
Assume no short-sales constraint.

If there are no arbitrage opportunities for the finite horizon T,
then there is a strictly positive SDF process
1
,
2
,
.
If there are no arbitrage opportunities for each finite horizon T,
then there is an infinite horizon strictly positive SDF processes
1
,
2
, .
Absence of arbitrage => SDF exists => Law of one price.
State prices exist for each state => Market is complete.
FE8507/DR MANDY THAM/2014_2015 27
Example: Covered interest parity
Covered interest parity condition links spot and forward foreign
exchange markets to foreign and domestic money markets using the law
of one price.

0
:current date 0 forward price for exchanging one unit of a foreign
currency T periods in the future. At t=T, you pay
0
dollars for delivery
of one unit of the foreign currency.

0
: Spot price of foreign exchange. At t=0, you pay
0
dollars for delivery
of one unit of the foreign currency.

FE8507/DR MANDY THAM/2014_2015 28
At t = 0:
Construct a zero initial investment portfolio by selling forward one unit of foreign
exchange at price
0
. i.e. We are obligated to deliver one unit of foreign exchange
at t=T and receive
0
dollars.
Concurrently, buy
1
unit of foreign currency and invest

1
in a foreign bond yielding per-

period return
.
This will costs us
dollars.
We then borrow
dollars at per-period interest rate
.
Net initial investment = 0
FE8507/DR MANDY THAM/2014_2015 29
At t = T:
unit of foreign currency earnings per-period returns
over T periods gives 1

unit of foreign currency
We receive
0
dollars for delivery of one unit of foreign currency.
Our debt compounded over T periods:
)
Net proceeds:
0
-
)
By law of one price, we must have
0
=

0
.(13)
(3) is the covered interest parity condition.

FE8507/DR MANDY THAM/2014_2015 30
2.5 State prices and SDF
If we are willing to assume that there is a finite number of possible
future states of the world, we can express the pricing kernel in other
useful ways.
Suppose there are k possible states of the world and n assets.
Denote the payoff of asset i in state j as
.
Let security prices be given by the N-vector P.
Denoting portfolio weights by the N-vector .
Cost of the portfolio = P
Payoff of the portfolio =
FE8507/DR MANDY THAM/2014_2015 31
Within this framework, a state-price vector is defined to be a vector
q=(
1
,
)satisfying
11

1

(
1
,
) =
2
.
..(14)
Or simply,
=
A solution for q exists if X is full-rank (complete market).
=> law of one price holds
=> SDF exists
FE8507/DR MANDY THAM/2014_2015 32
Remember that all uncertainty in this model is about which state will be revealed in
the next period.
Let probability of state s = , then from 1 = E MR

1 =
=1
.(15)

Now, we have =
=1

1 =
=1
(16)

FE8507/DR MANDY THAM/2014_2015 33
Compare (15) and (16),
(15): 1 =
=1

(16): 1 =
=1

We have
.(17)

(18)
Thus, the SDF can also be represented by the state-price normalized by the
probability of the state occurring.
If
exists and is strictly positive, then
exist and is strictly positive.

FE8507/DR MANDY THAM/2014_2015 34
Concept check
Using (16): 1 =
=1

Derive the present value of an asset that pays out $1
regardless of the realized state in the next period.
What do you call this asset?
FE8507/DR MANDY THAM/2014_2015 35
Concept check
Given that states of nature occur randomly. Would you expect the state
price of a high dividend-yield stock to be higher during economic
recessions or during booms?

FE8507/DR MANDY THAM/2014_2015 36
2.5 State prices and the SDF
In sum,

When state prices exist, the SDF exists.

When the SDF exists, we have the pricing equation 1 = E MR and
the law of one price.

A dynamic security market is said to satisfy the law of one price if
0
=
0
whenever W and W* are self-financing processes that are

equal at any date t.
FE8507/DR MANDY THAM/2014_2015 37
2.6 Limits to Arbitrage
One typically can arbitrage when there are no market frictions
No short-sales constraints
Negligible transaction costs
Depth in the market
However there are limits to arbitrage in the real world.

Read The Limits of Arbitrage
by Andrei Shleifer and Robert W. Vishny, Journal of Finance, Vol. 52, No. 1.
(Mar., 1997), pp. 35-55.

FE8507/DR MANDY THAM/2014_2015 38
2.6 Limits to Arbitrage
Read Forbes article: Twitter's IPO Is More
Proof That Tech Is In A Massive Bubble.
Top chart: Total U.S. stock market
cap/GDP.
Bottom chart: S&P500 level.
Suppose you think that the
fair market cap/GDP ratio
should be one, will you
arbitrage in year 1996?
FE8507/DR MANDY THAM/2014_2015 39
2.7 Risk-Neutral Probability/Pricing
We can perform the same trick that produced a pricing kernel with any
sort of probability" that we care to consider. Many results use what is
sometimes called risk-neutral probabilities.
Using
=1

=
1
=1
=
1
=1
(20)
where
has the characteristics of probability.

1.
0
2.
=1
=
,

=1
=
,
1
,
= 1

FE8507/DR MANDY THAM/2014_2015 40
We can then write
=
1
=1
=
1
(
,
)

Since we have
=
1
,

Under risk-neutral pricing, we again have

=
1

,
=

,
(21)
We have changed the probability measure from the statistical
probability
to the risk-neutral probability
.

FE8507/DR MANDY THAM/2014_2015 41
Formally,
Suppose a money market account exists. Index this as asset 1. The risk-
free return from date t to t+1 is
1,+1
1,

A risk-neutral probability for < is defined to be a probability
measure Q where
1. For any event A, (A)=0 if and only if Q(A)=0.
2. For any asset i=2,n,
1
is a martingale on the time horizon (0,1,T)
relative to Q.
If 1 and 2 hold, and Q are called Equivalent Martingale Measure
FE8507/DR MANDY THAM/2014_2015 42
Thus,

,+1
,
=

1,+1
1,

(
,+1
)
,
=

1,+1
1,
=
,
(22)
Under risk-neutral probability Q, the expected return on each asset equal the risk-
free return.
Sub
,+1
,
=

,+1
+
,+1
,
into (22)
We have
(
,+1
+
,+1
)
,
=
,
(23)
To compute the price at t, compute the expectation of its value at t+1 and discount
by risk-free return.

FE8507/DR MANDY THAM/2014_2015 43
The mapping from -measure to Q-measure is called the Radon-
Nikodym derivative of Q with respect to , denoted by

Think of Radon-Nikodym derivative as the ratio of probability densities
under Q relative to .
Now you should understand why Q and must be equivalent measures.
Valuation via a risk-neutral probability is equivalent to valuation via
an SDF process.

FE8507/DR MANDY THAM/2014_2015 44
We have

1,
=
1,
..(24)

Proof:
Recall
, and
,
=
,

Therefore,

1,
=

1,
=1
=
,

1,
=
=1

1,
=1
=
1,

FE8507/DR MANDY THAM/2014_2015 45
We have

1,
1,0
..(25)
Proof:
Recall
,
Since
,
=
,
=

1,
1,0
= (

1,
1,0
=1
1
) =

1,
1,0

where 1
is an indicator function that takes on unity only when s=A.

FE8507/DR MANDY THAM/2014_2015 46
We also have
=

1,0
1,
..(26)
Proof:
Recall
,

Since
,
=
1,
1,0

1,0
1,
=
1
,
=

FE8507/DR MANDY THAM/2014_2015 47
2.8 Complete Markets
1) A dynamic securities market is said to be complete if, for every t, each
random variable x that depends only on date-t information is a marketed
date-t payoff.
A random variable x is marketed if it is the payoff of some portfolio.
Recall
11

1

(
1
,
) =
2
.

(1) means that [
]is linearly spanned by a set of marketed portfolios. In other

words, [
] is full rank and can be invested to find q.

FE8507/DR MANDY THAM/2014_2015 48
2.8 Complete Markets
If the market is complete and law of one price holds, then there
can be at most one SDF process because the condition
implies that
, since both
and
depend on date-t information.

If the market is complete and there is no arbitrage
opportunities, then there is a unique SDF process, and it is strictly
positive.

FE8507/DR MANDY THAM/2014_2015 49
2.9 Portfolio Choice in Complete Markets
Suppose an investor can choose any consumption process C satisfying
0
= [
=0
..(27)
Intertemporal budget constraint with no endowment is given by
+1
= (
+1

Using CRRA utility
()

Recall
(
+
)
)
=>
+1
=
..(28)
Iterating on (28), we have
=
0
..(29)
FE8507/DR MANDY THAM/2014_2015 50
2.9 Portfolio Choice in Complete Markets
From (27):
0
=
+[
=1

Sub (29), we have
0
=
+[
=1
=
+
0
[
1
1
=1

Which can be solved as
0
=

0
1+[
1
1
=1
.(30)
Sub (30) into (29),
=

0
1+[
1
1
=1
(31)
FE8507/DR MANDY THAM/2014_2015 51
Next week
Tutorial 2 presentation
Dynamic Programming, Chap 9, Back.
FE8507/DR MANDY THAM/2014_2015 52

FE 8507 Lecture 2 More On Dynamic Security Markets Students

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FE 8507 Stochastic Modelling in

in (1) is the shadow risk-free rate or

(money market fund)

measures consumption growth,

is interest rate, measures patience and is called a subjective

.(11) (Hint: use Taylors expansion)

0 with probability 1 and

> 0 with positive

0 with probability 1 and

> 0 with positive

unit of foreign currency and invest

in a foreign bond yielding per-

dollars at per-period interest rate

unit of foreign currency earnings per-period returns

over T periods gives 1

exists and is strictly positive, then

exist and is strictly positive.

whenever W and W* are self-financing processes that are

has the characteristics of probability.

to the risk-neutral probability

is an indicator function that takes on unity only when s=A.

]is linearly spanned by a set of marketed portfolios. In other

] is full rank and can be invested to find q.

depend on date-t information.

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