ASSET PRICING MODEL: Concluding remarks

For a long time, corporate finance has been treated as an appendix to asset pricing theory, with CAPM frequently used as the basic model for normative analyses of investment and financing decisions. While standard textbooks still reflect this tradition, the modern agency-theoretic literature is starting to influence the way corporate finance is taught. This paper takes the next logical step, which is to suggest that if financing and investment decisions reflect agency problems — as seems to be widely accepted — then it is likely that modern corporate finance will require adjustments in asset pricing theories, too.

Our paper is a very preliminary effort to analyze this reverse influence of corporate finance on asset pricing. We have employed a standard agency model in which part of the returns from a firm’s investment cannot be pledged to outsiders, raising a demand for long-term financing, that is, for liquidity. We have also assumed that individuals cannot pledge any of their future income, so that borrowing against human capital is impossible. As a result, the economy is typically capital constrained, implying that collateralizable assets are in short supply. Such assets will command a premium, which is determined by the covariation of the asset’s return with the marginal value of liquidity in different states. Risk neutral firms are willing to pay a premium on assets that help them in states of liquidity shortage. This is a form of risk aversion, but unlike in models based on consumer risk aversion, return variation within states that experience no liquidity shortage is inconsequential for prices. Here Thus, liquidity premia have a built-in skew.

One consequence of this skew is that price volatility tends to be higher in states of liquidity shortage, as we illustrated in Section 3. Another consequence is that long-term bonds, because of a higher price risk, tend to sell at a discount relative to short-term bonds as we showed in Section 4. This may be one reason why the yield curve most of the time is upward sloping, a feature that does not readily come out of a complete market model.

The price dynamics in our model satisfy standard Euler conditions — in particular, prices follow a martingale as long as there is no readjustment in the corporate sector’s coordinated investment plan. It is an interesting possibility that marginal rates of substitution for the corporate sector may be quite different, and perhaps more volatile in the short run, than the marginal rates of substitution of a representative consumer. This could help to resolve some of the empirical difficulties experienced with consumption-based asset pricing models, which appear to feature too little variation in MRSs.

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