# Asset Pricing (Graduate Program EIEF)

**Course Description**

The topics and approaches combine macroeconomics and finance, with an emphasis on developing and testing theories which involve linkages between financial markets and the macro economy. This course is based on three ideas:

First, returns are not random walks but are predictable over business cycle and longer horizons. Thus, we need macroeconomic models that generate predictability - through time-varying risk aversion for example - and appropriate empirical methods to estimate them.

Second, all financial assets can be understood using a stochastic discount factor m and a description of their payoff X. The price

*P*of a financial asset is then simply =*E(MX*). Macroeconomic model give us ideas about the form of the stochastic discount factor M. GMM estimators give us a natural framework to test these ideas.Third, time varying risk premium dramatically changes portfolio theory, leading to new computing issues and solutions to old Merton problems.

This course is thus a survey of both asset pricing theory and empirical methods. We will cover the modern stochastic discount factor approach to asset pricing theory, with applications to stocks, bonds and currencies. We will cover empirical methods, including how to evaluate asset pricing models and how to evaluate forecasting techniques. We will go back and forth between macroeconomic and financial theories and empirical tests of these theories.

**Detailed Program**

Class 1: A look at the data [slides]

required readings: Dimson, Elroy, Marsh, and Staunton (2016), "Equity Premia Around the World", Working Paper [link]; Jorion and Goetzmann (1999), "Global Stock Markets in the Twentieth Century", Journal of Finance 54 [link]

additional (non-required) reading (particularly useful if you do not have any background in finance): Campbell, Lo and MacKinlay (1997), *The Econometrics of Financial Markets* (chapter 1); Cochrane (2006), Investment Notes [link]

Class 2: Lucas' tree model [notes][notes on evelope theorem]

required reading: Cochrane (2017), "Macro-Finance", Review of Finance, [link]

additional (non-required) readings: Lucas (1978), "Asset Prices in an Exchange Economy", Econometrica 46; Ljungquist and Sargent (2012), *Recursive Macroeconomic Theory*, MIT Press, Third Edition (chapter 1, section 3.8, and chapter 2)

*Problem set 1* [link]: we will discuss the solutions to the problem set in class next Thursday. I expect everyone being able to participate to the discussion

Class 3: The basic pricing equation P=E(MX) [notes]

required reading: Cochrane (2005), chapter 1

additional (non-required) reading: Ljungquist and Sargent (2012), *Recursive Macroeconomic Theory*, MIT Press, Third Edition (chapter 13)

Class 4: Risk-free rate and risk adjustment [notes1 notes2]

required reading: Cochrane (2005), chapter 2

Class 5: In-class discussion of problem set 1 (theory)

Class 6: In-class discussion of problem set 1 (Matlab code): to run the code that solves Lucas (78)'s tree model as presented in class, save all the scripts in the same folder [codes]

Class 7: Term structure, price-dividend ratio, expected returns [notes]

required reading: Cochrane (2011), "Discount Rates", Journal of Finance [link]; Fama and French (1996), "Multifactor Explanations of Asset Pricing Anomalies" [link]

additional (non-required) readings: Ljungquist and Sargent (2012), *Recursive Macroeconomic Theory*, MIT Press, Third Edition (chapter 14)

*Problem set 2* [text - data]: we will discuss the solutions to the problem set in class next Thursday. I expect everyone being able to participate to the discussion

Class 8: CCAPM, Fama-MacBeth Estimation, mean-variance frontier, Hansen-Jagannathan bounds [notes]

Class 9: Campbell-Shiller identity, predictability, long-run return regressions [notes]

Required reading: Cochrane (1999), New Facts in Finance [link]

Required reading: Cochrane (2005), chapter 20

Class 10: In-class discussion of problem set 2 [matlab code]

Class 11: Contingent claims [notes]

Required reading: Cochrane (2005), chapter 3

Class 12: Contingent claims (cont'd) [notes] and Factor Models [notes]

Required reading: Cochrane (2005), chapter 4 and 9

Class 13: Heterogenous agents models [notes]

Required reading: Cochrane (2005), chapter 21

Required reading: Constantinides and Duffie (JPE 1996) [pdf]

Class 14: Habit models

Required reading: Campbell and Cochrane (JPE 1999) [pdf]

Class 15: Habit models [slides]

Required reading: Wachter (FRC 2005) [pdf]