1. Microfoundations of Financial Economics 2004-2005 1
Microfoundations of Financial Economics Empirical challenges
Professor André Farber
Solvay Business School
Université Libre de Bruxelles

2. Theory of asset pricing under certainty
1930
Fisher Theory of Interest
Williams Theory of Investment Value
1940
1950
Hirshleifer Theory of Optimal Investment Decisions
1960
PhD 01-1

3. Theory of asset pricing under uncertainty
1950
Markowitz Portfolio theory
Arrow State prices
1960
Arrow Debreu General equilibrium
Sharpe Lintner CAPM
1970
Black Scholes Merton OPM
Ross APT
Lucas Asset Prices
Ross Risk neutral pricing
Vasiceck Term structure
Cox Ross Rubinstein Binomial OPM
Harrison Kreps Martingales
1980
“Theoretical developments in the period since 1979, with relatively few exceptions, have been a mopping-up operation.”
Duffie,D. Dynamic Asset Pricing Theory, 3d ed. Princeton Universiy Press 2001
1990
Cochrane – Campbell: p = E(MX)
2000
PhD 01-1

4. Three views of asset pricing
General equilibrium
Mean variance efficiency
Beta pricing
Stochastic discount factors
Factor model + No arbitrage
Risk-neutral pricing
State prices linear pricing rule
Complete markets No arbitrage (NA) Law of one price (LOOP)
Adapted from Cochrane Figure 6.1
PhD 01-1

5. “Old” finance 1. CAPM Only systematic risk (beta) matters
High average returns are associated with high betas
Nothing else matters
2. Returns are unpredictable
Stocks: Random Walk – Efficient market hypothesis
Bonds: Expectation model of the term structure
Foreign exchange
PhD 01-1

6. For practitioners
Calculate NPV using the CAPM for calculating the cost of capital
What is the proper risk free rate?
Uses constant market risk premium
Assumes constant beta
otherwise
Option pricing model
Invest in the market portfolio
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7. Empirical challenges Explaining the cross section of returns
Explaining changes in expected returns
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8. Beta
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9. PhD 01-1

10. Size and B/M
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11. File: 25_Portfolios_5x5_monthly.xls
Based on monthly data
File: 25_Portfolios_5x5_monthly.xls
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12. Fama French
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13. Predictability: Interest Rates and Expected Inflation
Sample period (Sample Size) γ
(2,053)
(-3.50)
(1,136)
(-4.58)
(324)
0.114 (0.03)
(228)
(-2.57)
(357)
(-1.08)
Schwert, W., Anomalies and Market Efficiency,WP October
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14. Predictability: D/P
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15. Predictability
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16. PhD 01-1

17. Econometrician wanted…
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