We estimate the parameters of pricing kernels that depend on both aggregate wealth and state variables that describe the investment opportunity set, using FTSE 100 and S&P 500 index option returns as the returns to be priced. The coefficients of the state variables are highly significant and remarkably consistent across specifications of the pricing kernel, and across the two markets. The resul...

This paper studies the performance of portfolio rules in incomplete markets for long-lived assets with endogenous prices. The dynamics of wealth shares in the process of repeated reinvestment of wealth is modelled as a random dynamical systems. The performance of a portfolio rule is determined by the wealth share eventually conquered in competition with other rules. We derive necessary and suff...

Concepts of constant absolute risk aversion and constant relative risk aversion have proved useful in the analysis of choice under uncertainty, but are quite restrictive, particularly when they are imposed jointly. A generalization of constant risk aversion, referred to as invariant risk aversion is developed. Invariant risk aversion is closely related to the possibility of representing prefere...

Beta as a measure of risk has been under fire for many years. Although practitioners still widely use the CAPM to estimate the cost of equity of companies, they are aware of its problems and are looking for alternatives. A possible alternative is to estimate the cost of equity based on the semideviation. a well-known and intuitively plausible measure of downside risk. Complementing evidence rep...

We derive a model in which a standard international capital asset pricing model (ICAPM) is nested within an ICAPM with market imperfections. In the latter model an idiosyncratic stochastic factor affects the return of risky government bonds (over a risk-free rate) on top of the systematic component that is common to all countries (and that is interacted with a time-varying idiosyncratic “beta”)...

Under the assumption of normally distributed returns, we analyze whether the Cumulative Prospect Theory of Tversky and Kahneman (1992) is consistent with the Capital Asset Pricing Model. We find that in every financial market equilibrium the Security Market Line Theorem holds. However, under the specific functional form suggested by Tversky and Kahneman (1992) financial market equilibria do not...

The intertemporal capital asset pricing model of Merton (1973) is examined using the dynamic conditional correlation (DCC) model of Engle (2002). The mean-reverting DCC model is used to estimate a stock’s (portfolio’s) conditional covariance with the market and test whether the conditional covariance predicts time-variation in the stock’s (portfolio’s) expected return. The risk-aversion coeffic...

Established illiquidity measures are constructed for emerging markets in Africa and used to determine which best explain trading costs. Costs of equity are derived from an augmented CAPM for a sample of emerging financial markets generally ignored in the literature. These include: South Africa and Namibia, three countries in North Africa and four in SSA, plus London and Paris as examples of int...

We consider some further applications of martingale pricing to problems in financial engineering. In particular, we will show how dynamic portfolio optimization problems in complete markets may be solved using martingale pricing methods. We will see, as a result, how the problems of security pricing and portfolio optimization are very closely related. We then introduce real options and discuss ...

We investigate the analytical and empirical linkages between cash flow, uncertainty and firms’ capital investment behavior. Our empirical approach constructs measures of ownand market-specific uncertainty from firms’ daily stock returns and S&P 500 index returns along with a CAPM-based risk measure. Our results indicate that even in the presence of important firm-specific variables, uncertainty...