Financial Decisions and Markets

John Y. Campbell is the Morton L. and Carole S. Olshan Professor of Economics at Harvard University. His books include The Econometrics of Financial Markets (Princeton) and Strategic Asset Allocation: Portfolio Choice for Long-Term Investors.

"John Campbell is one of the leading researchers and teachers in asset pricing. This remarkably clear and well-organized book is strong testimony to his expertise. I will use it often in my own research."—Kenneth R. French, Dartmouth College

• FiguresTablesPrefacePart I Static Portfolio Choice and Asset Pricing1 Choice under Uncertainty1.1 Expected Utility1.1.1 Sketch of von Neumann-Morgenstern Theory1.2 Risk Aversion1.2.1 Jensen’s Inequality and Risk Aversion1.2.2 Comparing Risk Aversion1.2.3 The Arrow-Pratt Approximation1.3 Tractable Utility Functions1.4 Critiques of Expected Utility Theory1.4.1 Allais Paradox1.4.2 Rabin Critique1.4.3 First-Order Risk Aversion and Prospect Theory1.5 Comparing Risks1.5.1 Comparing Risks with the Same Mean1.5.2 Comparing Risks with Different Means1.5.3 The Principle of Diversification1.6 Solution and Further Problems2 Static Portfolio Choice2.1 Choosing Risk Exposure2.1.1 The Principle of Participation2.1.2 A Small Reward for Risk2.1.3 The CARA-Normal Case2.1.4 The CRRA-Lognormal Case2.1.5 The Growth-Optimal Portfolio2.2 Combining Risky Assets2.2.1 Two Risky Assets2.2.2 One Risky and One Safe Asset2.2.3 N Risky Assets2.2.4 The Global Minimum-Variance Portfolio2.2.5 The Mutual Fund Theorem2.2.6 One Riskless Asset and N Risky Assets2.2.7 Practical Difficulties2.3 Solutions and Further Problems3 Static Equilibrium Asset Pricing3.1 The Capital Asset Pricing Model (CAPM)3.1.1 Asset Pricing Implications of the Sharpe-Lintner CAPM3.1.2 The Black CAPM3.1.3 Beta Pricing and Portfolio Choice3.1.4 The Black-Litterman Model3.2 Arbitrage Pricing and Multifactor Models3.2.1 Arbitrage Pricing in a Single-Factor Model3.2.2 Multifactor Models3.2.3 The Conditional CAPM as a Multifactor Model3.3 Empirical Evidence3.3.1 Test Methodology3.3.2 The CAPM and the Cross-Section of Stock Returns3.3.3 Alternative Responses to the Evidence3.4 Solution and Further Problems4 The Stochastic Discount Factor4.1 Complete Markets4.1.1 The SDF in a Complete Market4.1.2 The Riskless Asset and Risk-Neutral Probabilities4.1.3 Utility Maximization and the SDF4.1.4 The Growth-Optimal Portfolio and the SDF4.1.5 Solving Portfolio Choice Problems4.1.6 Perfect Risksharing4.1.7 Existence of a Representative Agent4.1.8 Heterogeneous Beliefs4.2 Incomplete Markets4.2.1 Constructing an SDF in the Payoff Space4.2.2 Existence of a Positive SDF4.3 Properties of the SDF4.3.1 Risk Premia and the SDF4.3.2 Volatility Bounds4.3.3 Entropy Bound4.3.4 Factor Structure4.3.5 Time-Series Properties4.4 Generalized Method of Moments4.4.1 Asymptotic Theory4.4.2 Important GMM Estimators4.4.3 Traditional Tests in the GMM Framework4.4.4 GMM in Practice4.5 Limits of Arbitrage4.6 Solutions and Further ProblemsPart II Intertemporal Portfolio Choice and Asset Pricing5 Present Value Relations5.1 Market Efficiency5.1.1 Tests of Autocorrelation in Stock Returns5.1.2 Empirical Evidence on Autocorrelation in Stock Returns5.2 Present Value Models with Constant Discount Rates5.2.1 Dividend-Based Models5.2.2 Earnings-Based Models5.2.3 Rational Bubbles5.3 Present Value Models with Time-Varying Discount Rates5.3.1 The Campbell-Shiller Approximation5.3.2 Short- and Long-Term Return Predictability5.3.3 Interpreting US Stock Market History5.3.4 VAR Analysis of Returns5.4 Predictive Return Regressions5.4.1 Stambaugh Bias5.4.2 Recent Responses Using Financial Theory5.4.3 Other Predictors5.5 Drifting Steady-State Models5.5.1 Volatility and Valuation5.5.2 Drifting Steady-State Valuation Model5.5.3 Inflation and the Fed Model5.6 Present Value Logic and the Cross-Section of Stock Returns5.6.1 Quality as a Risk Factor5.6.2 Cross-Sectional Measures of the Equity Premium5.7 Solution and Further Problems6 Consumption-Based Asset Pricing6.1 Lognormal Consumption with Power Utility6.2 Three Puzzles6.2.1 Responses to the Puzzles6.3 Beyond Lognormality6.3.1 Time-Varying Disaster Risk6.4 Epstein-Zin Preferences6.4.1 Deriving the SDF for Epstein-Zin Preferences6.5 Long-Run Risk Models6.5.1 Predictable Consumption Growth6.5.2 Heteroskedastic Consumption6.5.3 Empirical Specification6.6 Ambiguity Aversion6.7 Habit Formation6.7.1 A Ratio Model of Habit6.7.2 The Campbell-Cochrane Model6.7.3 Alternative Models of Time-Varying Risk Aversion6.8 Durable Goods6.9 Solutions and Further Problems7 Production-Based Asset Pricing7.1 Physical Investment with Adjustment Costs7.1.1 A q-Theory Model of Investment7.1.2 Investment Returns7.1.3 Explaining Firms’ Betas7.2 General Equilibrium with Production7.2.1 Long-Run Consumption Risk in General Equilibrium7.2.2 Variable Labor Supply7.2.3 Habit Formation in General Equilibrium7.3 Marginal Rate of Transformation and the SDF7.4 Solution and Further Problem8 Fixed-Income Securities8.1 Basic Concepts8.1.1 Yields and Holding-Period Returns8.1.2 Forward Rates8.1.3 Coupon Bonds8.2 The Expectations Hypothesis of the Term Structure8.2.1 Restrictions on Interest Rate Dynamics8.2.2 Empirical Evidence8.3 Affine Term Structure Models8.3.1 Completely Affine Homoskedastic Single-Factor Model8.3.2 Completely Affine Heteroskedastic Single-Factor Model8.3.3 Essentially Affine Models8.3.4 Strong Restrictions and Hidden Factors8.4 Bond Pricing and the Dynamics of Consumption Growth and Inflation8.4.1 Real Bonds and Consumption Dynamics8.4.2 Permanent and Transitory Shocks to Marginal Utility8.4.3 Real Bonds, Nominal Bonds, and Inflation8.5 Interest Rates and Exchange Rates8.5.1 Interest Parity and the Carry Trade8.5.2 The Domestic and Foreign SDF8.6 Solution and Further Problems9 Intertemporal Risk9.1 Myopic Portfolio Choice9.2 Intertemporal Hedging9.2.1 A Simple Example9.2.2 Hedging Interest Rates9.2.3 Hedging Risk Premia9.2.4 Alternative Approaches9.3 The Intertemporal CAPM9.3.1 A Two-Beta Model9.3.2 Hedging Volatility: A Three-Beta Model9.4 The Term Structure of Risky Assets9.4.1 Stylized Facts9.4.2 Asset Pricing Theory and the Risky Term Structure9.5 Learning9.6 Solutions and Further ProblemsPart III Heterogeneous Investors10 Household Finance10.1 Labor Income and Portfolio Choice10.1.1 Static Portfolio Choice Models10.1.2 Multiperiod Portfolio Choice Models10.1.3 Labor Income and Asset Pricing10.2 Limited Participation10.2.1 Wealth, Participation, and Risktaking10.2.2 Asset Pricing Implications of Limited Participation10.3 Underdiversification10.3.1 Empirical Evidence10.3.2 Effects on the Wealth Distribution10.3.3 Asset Pricing Implications of Underdiversification10.4 Responses to Changing Market Conditions10.5 Policy Responses10.6 Solutions and Further Problems11 Risksharing and Speculation11.1 Incomplete Markets11.1.1 Asset Pricing with Uninsurable Income Risk11.1.2 Market Design with Incomplete Markets11.1.3 General Equilibrium with Imperfect Risksharing11.2 Private Information11.3 Default11.3.1 Punishment by Exclusion11.3.2 Punishment by Seizure of Collateral11.4 Heterogeneous Beliefs11.4.1 Noise Traders11.4.2 The Harrison-Kreps Model11.4.3 Endogenou Margin Requirements11.5 Solution and Further Problems12 Asymmetric Information and Liquidity12.1 Rational Expectations Equilibrium12.1.1 Fully Revealing Equilibrium12.1.2 Partially Revealing Equilibrium12.1.3 News, Trading Volume, and Returns12.1.4 Equilibrium with Costly Information12.1.5 Higher-Order Expectations12.2 Market Microstructure12.2.1 Information and the Bid-Ask Spread12.2.2 Information and Market Impact12.2.3 Diminishing Returns in Active Asset Management12.3 Liquidity and Asset Pricing12.3.1 Constant Trading Costs and Asset Prices12.3.2 Random Trading Costs and Asset Prices12.3.3 Margins and Asset Prices12.3.4 Margins and Trading Costs12.4 Solution and Further ProblemsReferencesIndex