ASSET PRICING MODEL: The yield curve 4

The price differential between short- and long-term bonds here reflects a more general theme, namely that the liquidity approach to asset pricing implies a skewness in risk tolerance. What matters is the average coupon delivered in states of pressing liquidity need. The term premium stems from the fact that a short-term bond delivers 1 unit […]

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ASSET PRICING MODEL: The yield curve 3

Long-term bonds and the Hirshleifer effect In order to obtain some preliminary insights into the effects of liquidity on the term structure, let us again return to the example of section 2.21 Assume that the government at date 0 issues two types of bonds: I short-term bonds yielding one unit of the good at date […]

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ASSET PRICING MODEL: The yield curve 2

The yield curve is most commonly upward sloping, although it may occasionally be hump-shaped or inverted or even have an inverted-hump-shape (see, Campbell et al., 1996, Campbell, 1995, and Stigum, 1990). The substantially higher yield on 6 month- than on 1 month-T bills has been labelled a “term premium puzzle.”20 It is often argued that […]

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ASSET PRICING MODEL: The yield curve

With only one liquidity-constrained state, the price in information state an of an asset к with constant expected dividend is, as we have seen,

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ASSET PRICING MODEL: LAPM 7

Asset prices (or liquidity premia) form a martingale because there is no liquidity service within the periods where news arrives. Only at the last subdate (date 1) will the liquidity premium disappear and hence the martingale property fail. Note that the martingale condition reflects the fact that firms are indifferent regarding the timing of the […]

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ASSET PRICING MODEL: LAPM 6

In words, the volatility of the Treasury bond price is state contingent, and the higher the volatility, the worse the prospects for the economy. The simple logic is that volatility is high when the option is in the money and low when it is out of the money. Remark: In the example with nonverifiable second-period […]

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ASSET PRICING MODEL: LAPM 5

Information filtering and volatility As we noted in the introduction, many recent advances in empirical finance were motivated by the observation that conditional variances and covariances change over time. It is well-known, for instance, that volatility is clustered, that asset volatilities (stock volatilities, bond volatilities across maturities) move together, and that stock volatility increases with […]

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ASSET PRICING MODEL: LAPM 4

Single state of liquidity shortage. Suppose liquidity is scarce in a single state, шн, which has probability /я-According to (10), the liquidity premium on asset к is then proportional to the asset’s payoff conditional on the occurrence of the bad state: as the single factor. That is, if дь is the date-0 price of a […]

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ASSET PRICING MODEL: LAPM 3

The corporate sector solves:

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ASSET PRICING MODEL: LAPM 2

The net investment N(I) is only part of the investors’ date-0 contribution to the corporate sector. The corporate sector also purchases noncorporate assets {Lk}k=i,.. date 0. The investors’ date-0 outlay is thus In equilibrium all claims commanding a liquidity premium [q^ > 1) must be held by the corporate sector (Lfc = Lfc), because consumers […]

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