Microfoundations of financial economics

Microfoundations of Financial Economics

Microfoundations of Financial Economics: An Introduction to General Equilibrium Asset Pricing
IS A PART OF THE

PRINCETON SERIES IN FINANCE

SERIES EDITORS Darrell Duffie Stanford University Stephen Schaefer London Business School

Finance as a discipline has been growing rapidly. The number of researchers in academy and industry, of students, ofmethods and models have all proliferated in the past decade or so. This growth and diversity manifests itself in the emerging cross-disciplinary as well as cross-national mix of scholarship now driving the field of finance forward. The intellectual roots of modern finance, as well as the branches, will be represented in the Princeton Series in Finance. Titles in the series will be scholarly andprofessional books, intended to be read by a mixed audience of economists, mathematicians, operations research scientists, financial engineers, and other investment professionals. The goal is to provide the finest cross- disciplinary work, in all areas of finance, by widely recognized researchers in the prime of their creative careers. OTHER BOOKS IN THIS SERIES Financial Econometrics: Problems, Models,and Methods by Christian Gourieroux and Joann Jasiak Credit Risk: Pricing, Measurement, and Management by Darrell Duffie and Kenneth J. Singleton

Microfoundations of Financial Economics
An Introduction to General Equilibrium Asset Pricing

Yvan Lengwiler

Princeton University Press Princeton and Oxford

Copyright © 2004 by Princeton University Press Published by Princeton UniversityPress, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 3 Market Place, Woodstock, Oxfordshire OX20 1SY All rights reserved Library of Congress Cataloguing-in-Publication Data Lengwiler, Yvan. Microfoundations of financial economics: an introduction to general equilibrium asset pricing / Yvan Lengwiler. p. cm. — (Princeton series in finance) Includesbibliographical references and index. ISBN 0-691-11315-7 (cloth : alk. paper) 1. Finance. 2. Economics. 3. Capital assets pricing model. I. Title. II. Series. HG173.L46 2004 332’.01’5195—dc22 2003066415 British Library Cataloguing-in-Publication Data is available This book has been composed in New Baskerville by Deerpark Publishing Services, Republic of Ireland Printed on acid-free paper.www.pup.princeton.edu Printed in the United States of America 10 9 8 7 6 5 4 3 2 1
∞

To Brigitte, with love

This page intentionally left blank

Contents

List of boxes Preface 1 Introduction 1.1 What finance theory is about 1.2 Some history of thought 1.3 The importance of the puzzles 1.4 Outline of the book 2 Contingent claim economy 2.1 The commodity space 2.2 Preferences and ordinal utility2.3 Maximization 2.4 General equilibrium 2.5 The representative agent Notes on the literature Problems 3 Asset economy 3.1 Financial assets 3.2 Pricing by redundancy 3.3 Radner economies 3.4 Complete markets (and uniqueness of Arrow prices) 3.5 Complications arising from market incompleteness Notes on the literature Problems 4 Risky decisions

xi xiii 1 1 2 7 9 10 10 14 16 23 32 35 35 37 37 41 4653 60 65 65 68

viii 4.1 Bernoulli’s St. Petersburg paradox 4.2 Using more structure: probabilities and lotteries 4.3 The von Neumann–Morgenstern representation 4.4 Measures of risk preference 4.5 Assumptions and evidence 4.6 Often used specifications Notes on the literature Problems 5 Static finance economy 5.1 An economy with von Neumann–Morgenstern agents 5.2 Efficient risk-sharing 5.3 Arepresentative NM agent 5.4 Who holds what kind of portfolio? 5.5 The stochastic discount factor 5.6 The equilibrium price of time 5.7 The equilibrium price of risk 5.8 Some important special cases Notes on the literature Problems 6 Dynamic finance economy 6.1 A static dynamic model 6.2 Dynamic trading 6.3 Models of the real interest rate 6.4 Portfolio selection Notes on the literature Problems 7...