Asset Pricing John H. Cochrane June 12, 2000

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Acknowledgments This book owes an enormous intellectual debt to Lars Hansen and Gene Fama. Most of the ideas in the book developed from long discussions with each of them, and trying to make sense of what each was saying in the language of the other. I am also grateful to all my colleagues in Finance and Economics at the University of Chicago, and to George Constantinides especially, for many discussions about the ideas in this book. I thank George Constantinides, Andrea Eisfeldt, Gene Fama, Wayne Ferson, Owen Lamont, Anthony Lynch, Dan Nelson, Alberto Pozzolo, Michael Roberts, Juha Seppala, Mike Stutzer, Pietro Veronesi, an anonymous reviewer, and several generations of Ph.D. students at the University of Chicago for many useful comments. I thank the NSF and the Graduate School of Business for research support. Additional material and both substantive and typographical corrections will be maintained at http://www-gsb.uchicago.edu/fac/john.cochrane/research/papers Comments and suggestions are most welcome This book draft is copyright c° John H. Cochrane 1997, 1998, 1999, 2000 John H. Cochrane Graduate School of Business University of Chicago 1101 E. 58th St. Chicago IL 60637 773 702 3059 john.cochrane@gsb.uchicago.edu June 12, 2000 2
Contents Acknowledgments 2 Preface 8 Part I. Asset pricing theory 12 1 Consumption-based model and overview 13 1.1 Basic pricing equation 14 1.2 Marginal rate of substitution/stochastic discount factor 16 1.3 Prices, payoffs and notation 17 1.4 Classic issues in finance 20 1.5 Discount factors in continuous time 33 1.6 Problems 38 2 Applying the basic model 41 2.1 Assumptions and applicability 41 2.2 General Equilibrium 43 2.3 Consumption-based model in practice 47 2.4 Alternative asset pricing models: Overview 49 2.5 Problems 51 3 Contingent Claims Markets 54 3.1 Contingent claims 54 3.2 Risk neutral probabilities 55 3.3 Investors again 57 3.4 Risk sharing 59 3.5 State diagram and price function 60 4 The discount factor 64 4.1 Law of one price and existence of a discount factor 64 4.2 No-Arbitrage and positive discount factors 69 3
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Page 5 and 6: 9.2 Intertemporal Capital Asset Pri
Page 7 and 8: 19.2 Yield curve and expectations h
Page 9 and 10: Asset pricing problems are solved b
Page 11 and 12: try to focus on the basic ideas and
Page 13 and 14: Chapter 1. Consumption-based model
Page 15 and 16: SECTION 1.1 BASIC PRICING EQUATION
Page 17 and 18: discount factors, SECTION 1.3 PRICE
Page 19 and 20: SECTION 1.4 CLASSIC ISSUES IN FINAN
Page 23 and 24: equation (1.2) as SECTION 1.4 CLASS
Page 25 and 26: ate! In equations, if then SECTION
Page 33 and 34: SECTION 1.5 DISCOUNT FACTORS IN CON
Page 39 and 40: SECTION 1.6 PROBLEMS function with
Page 41 and 42: Chapter 2. Applying the basic model
Page 43 and 44: SECTION 2.2 GENERAL EQUILIBRIUM mig
Page 45 and 46: C t+1 SECTION 2.2 GENERAL EQUILIBRI
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Page 51 and 52: SECTION 2.5 PROBLEMS Since the opti
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that function. From SECTION 2.5 PRO
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SECTION 3.2 RISK NEUTRAL PROBABILIT
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The discount factor prices the asse
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SECTION 3.4 RISK SHARING Asset pric
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State 2 Payoff SECTION 3.5 STATE DI
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SECTION 3.5 STATE DIAGRAM AND PRICE
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SECTION 4.1 LAW OF ONE PRICE AND EX
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SECTION 4.1 LAW OF ONE PRICE AND EX
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SECTION 4.2 NO-ARBITRAGE AND POSITI
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so SECTION 4.3 AN ALTERNATIVE FORMU
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Chapter 5. Mean-variance frontier a
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SECTION 5.1 EXPECTED RETURN -BETA R
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SECTION 5.2 MEAN-VARIANCE FRONTIER:
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SECTION 5.3 AN ORTHOGONAL CHARACTER
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SECTION 5.3 AN ORTHOGONAL CHARACTER
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SECTION 5.4 SPANNING THE MEAN-VARIA
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SECTION 5.5 A COMPILATION OF PROPER
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SECTION 5.5 A COMPILATION OF PROPER
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SECTION 5.6 MEAN-VARIANCE FRONTIERS
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SECTION 5.6 MEAN-VARIANCE FRONTIERS
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SECTION 5.7 PROBLEMS Hansen-Jaganna
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SECTION 6.1 FROM DISCOUNT FACTORS T
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Asset Pricing John H. Cochrane June 12, 2000

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