Essays on rational asset pricing

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Essays on rational asset pricing

Departures from rational expectation and asset pricing anomalies. Once one introduces into the SEU maximization Eden the snake of boundedness, it becomes difficult to find a univocal meaning of rationality, hence a unique theory of how people will, or should, decide".

Herbert Simon Introduction Financial markets have been understood over time with models that have certain basic assumption. The mainstream approach is to assume that the representative agent is rational and as such makes decisions that are optimal.

Rationality implies that the representative agent has the ability to reason and when confronted with new information is able to update his belief correctly in accordance to Bayes' theory i. There are two basic principles upon which the ideology of rationalism rest. Firstly, the decisions made under the rational choice behavior are consistent over time and are widely accepted and it implies that these decisions have to be made in a systematically and coherent way at all times.

Secondly, agents make choices that are consistent with the concept of Subjective Expected Utility. This concept, promoted by Savage J is a method of making decisions in the presence on risk and he postulates that a rational agent will make decisions that seek to maximize expected utility, and it implies that the rational agent will always seek self-interest.

This traditional approach to finance and the simplicity of its assumptions has brought rigour to study of financial markets as it seeks to explain price behavior based on investor rationality. While this approach has brought about theories and applications to the study of finance, there has been growing interest in the realism of these assumptions, its predictive power and its testability.

In reality, agents are perceived not to be fully rational and given the actual level of the aggregate stock market, the cross section of average returns over time and the behavior of individual trading agents, the basic fundamentals of the markets cannot be fully explain under the rational, agent utility maximizing framework.

Behavioural Finance represents a new approach to the study of financial markets that has emerged following the gaps, difficulties and empirical results that appear inconsistent with the rational assumptions of the traditional approach.

Behavioural finance rejects the ideology that the representative agent's behavior is based on the maximization of expected utility and seeks to explain market performance and financial phenomena if certain assumptions of rationality are relaxed.

One of the key objectives of behavioural finance is to investigate the effect and implication of the psychological traits of the representative agents on market performance and it can also be seen as an alternative hypothesis to that of rationality under which the alternative hypothesis accommodates departures from rational expectation.

This literature review will be structured as follows. The first part discusses briefly rational asset pricing models and evidence based anomalies on stock returns identified in in the behavioural finance literature which will form the basis of this review.

The second part discusses behavioural finance as an alternative to rational expectation theories. Finally, the last part contains concluding remarks. Under this assumption, the agent is assumed to derive utility from consumption in a time varying manner and the marginal utility of consumption is diminishing so that the agent's utility function is concave.

The assumption of rationality implies that the representative agent has the ability to reason and is able to update his belief correctly in accordance to Bayes' theory when faced with new information, this suggest that the agent knows the actual distribution of asset returns.

This assumption forms the basis of the Efficient Market Hypothesis which states that stocks already reflect all available information and since prices are determined rationally, only new information will cause a change in prices. The statement of the efficient market hypothesis holds that: Although the analysis above discusses intertemporal asset pricing, the fundamentals remain the same for any other asset pricing theory and equation 3 and 4 embodies the standard approach to asset pricing under the assumption of rationality and also defines the Efficient Market Hypothesis.

Fama in postulating the Efficient Market Hypothesis, asserts that asset prices reflect their fundamental value and no investment strategy is expected to earn excess risk adjusted average returns and any deviation from this fundamental values will be corrected by arbitrage.

However, in recent years theoretical and empirical evidence have shown that assets are not priced rationally and neither do they reflect all available information. These anomalies have been shown consistent over time in and out of sample and still persist even after adjusting for risk.

Essays on Rational Asset Pricing.

Literature has documented several anomalies and some of the pervasive ones are: Equity Premium Puzzle a.Chapter I The QUARREL ON THE CAPM: A LITERATURE SURVEY Abstract. The current chapter has attempted to do three things.

First it presents an overview on the capital asset pricing model and the results from . research papers; Tags. Portfolio Diversification and the Capital Asset Pricing Model.

What is the expected market return if the expected return on asset X is 20 percent, its beta is , and the risk free rate is 5 percent? (Please calculate the arithmetic solution and show your work). Portfolio diversification and the Capital Asset Pricing Model Risk and return, portfolio diversification and the Capital Asset Pricing Model; The cost of equity Required/Case Assignment/SLP Reading Dividend Growth Models ().

Essays on rational asset pricing

Security Risk Essay; Sally Bingham”s life; Media effects – The questions are designed to get. Discuss the concept of the Capital Asset Pricing Model and its importance in finance. Explain what drives expected return, and describe the security market line and its use.

HOW TO ACCESS ESSAYS HERE. Module 3 - CaseTHE CAPITAL ASSET PRICING MODELAssignment Overview1. For each of the scenarios below, explain whether or not it represents a diversifiable or an.

Abstract: Essays on Rational Asset Pricing is a collection of essays demonstrating the ability of rational asset pricing theory to explain differences in expected returns across assets.

Essays on rational asset pricing

The first two essays analyze the cross-sectional and time-series predictability of returns on commodity futures contracts.

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