Course Fin 7310, Section 001, Empirical Asset Pricing

Professor Yexiao Xu
Term Fall 2006
Meetings Wednesday, 9:30-12:15PM

Professor’s Contact Information

Office Phone (972)883-6703
Office Location SM 3.812 (School of Management Building)
Email Address yexiaoxu@utdallas.edu
Office Hours Monday 3:00-4:00PM and 6:30-7:30PM
Lecture notes and homework assignment will be distributed in class. Data can
Other
Information
be downloaded from my webpage: http://www.utdallas.edu/~yexiaoxu
Grades will be posted on WebCT, but I do not read WebCT mail!

General Course Information

Pre-requisites,
Co-requisites, & Meco 7320 and Fin 7310 (Asset Pricing)
other restrictions
This course provides an introduction to both empirical issues and empirical
methods with regard to asset pricing. One can never falsify a theory within
the boundary of its assumptions when correctly established. The empirical
challenge is to provide evidence either to support the theory or to “reject” the
theory. In practice, the supporting evidence for one theory could also be
consistent with the prediction of another theory. The question is whether the
evidence is more consistent with one theory than the other theory. Therefore,
careful specifications and sophisticated econometric techniques are needed in
order eliminate other possibilities. There are too many topics in this area. We
will focus on testing theories of asset price determination, with particular
attention to exploring the interplay between economic theory, statistical
Course assumptions, and relevant econometric techniques. In particular, we will start
Description with understanding the return process and how it should behave in an efficient
market. We will then move onto testing the classical CAPM theory in both
the unconditional form and conditional form. Perhaps the most elegant model
in asset pricing is the consumption based CAPM. We will investigate how
the theory evaluates against reality. Any asset pricing model can be
represented by the so-called stochastic discount factor model. It is important
to know if there are any restrictions on the characteristics of the stochastic
discount factor given the observed return process. Volatility plays an
important role in asset pricing (including derivate pricing), portfolio
allocation, and risk management. We will take a close look at the dynamic
behavior of volatility. If time permits, we will discuss some of the more
advanced techniques.
1. Understand the empirical issues in the area of asset pricing; and possess
working knowledge to understand current literature
Learning 2. Derive testable implications for asset pricing models; and implement
Outcomes efficient tests under different circumstance
3. Assess key issues and techniques in each of the following three areas: 1)
Return predictability; 2) Testing the CAPM; 3) The Conditional models
 Required Texts
The Econometrics of Financial Markets, Campbell, Lo, and MacKinlay
& Materials
Suggested Texts, William H. Greene, ECONOMETRIC ANALYSIS
Readings, & James D. Hamilton, Time Series Analysis
Materials John Cochrane, Asset Pricing

Assignments & Academic Calendar

Course Organization and Econometrics Review
Aug. 23 Asymptotic theory, violations to regression model assumptions, maximum likelihood
Lecture 1 estimator, generalized method of moments
Green: Chapter 12.4, 17, 18, Appendices A-D
Stock Return Characteristics
Aug. 30 Blattberg and Gonedes (1974), Campbell (1991), Richardson and Smith (1994),
Lecture 2 Tauchen and Pitts (1983)
Campbell, Lo, and MacKinlay: Chapter 1
Return Predictability—Short Run
Sep. 06 Boudoukh, Richardson, and Whitelaw (1994), Campbell and Shiller (1988), Lo
Lecture 3 and MacKinlay (1988), Conrad and Kaul (1988), Lewellen (2004)
Campbell, Lo, and MacKinlay: Chapter 2
Return Predictability—Long Run
Sep. 13
Poterba and Summers (1988), Fama and French (1988), Kirby (1997)
Lecture 4
Campbell, Lo, and MacKinlay: Chapter 2
Event Study
Sep. 20
Barber and Lyon (1997), Brown and Warner (1985)
Lecture 5
Campbell, Lo, and MacKinlay: Chapter 4
Testing the unconditional CAPM—Time-series approach
Sep. 27 Gibbons, Ross, and Shanken (1989), Gibbons and Ferson (1985), Fama and
Lecture 6 French (1993)
Campbell, Lo, and MacKinlay: Chapter 5
Testing the unconditional CAPM—Cross-sectional approach
Oct. 04 Fama and MacBeth (1974), Fama and French (1992), Kothari, Shanken, and Sloan
Lecture 7 (1995), Roll (1977), Malkiel and Xu (2005)
Campbell, Lo, and MacKinlay: Chapter 5
Testing the conditional CAPM
Oct. 11 Ferson and Harvey (1991), Jagannathan and Wang (1996), Ferson and Schadt
Lecture 8 (1996)
Campbell, Lo, and MacKinlay: Chapter 5
Oct. 18 Midterm exam
Consumption based CAPM
Oct. 25 Lucas (1978), Hansen and Singleton (1982), Breeden, Gibbons, and Litzenberger
Lecture 9 (1989), Campbell and Cochrane (2000)
Campbell, Lo, and MacKinlay: Chapter 8
Equity premium puzzle and HJ bound
Nov. 01 Campbell and Cochrane (1999), Mehra and Prescott (1985), Kocherlakota (1996),
Lecture 10 Hansen and Jagannathan (1997)
Campbell, Lo, and MacKinlay: Chapter 8
Conditional volatility
Nov. 08
Engle (1982), Bollerslev (1986), Nelson (1991)
Lecture 11
Campbell, Lo, and MacKinlay: Chapter 12
Nov. 15
Other Methodologies (Bootstrap, Bayesian, Markov Regime Switch)
Lecture 12
 Nov. 22
Other Methodologies (Bootstrap, Bayesian, Markov Regime Switch)
Lecture 13
Nov. 29 Final (Class Presentation)

Reading List
Reading List
Barber, B.M., and Lyon, J. D. (1997), “Detecting Long-Run Abnormal Stock
Returns: The Empirical Power and Specification of Test Statistics,” Journal of
Financial Economics 43, 341-372.

Blattberg, R., and Gonedes, N. (1974), “A Comparison of the Stable and

Student Distributions as Statistical Models for Asset Prices,” Journal of
Business 47(2), 244-280.

Bollerslev, Tim (1986), “Generalized Autoregressive Conditional

Heteroskedasticity,” Journal of Econometrics 31, 307-327.

Boudoukh, J., Richardson, M.P., and Whitelaw, R.F. (1994), “A Tale of Three
Schools: Insights on Autocorrelations of Short-Horizon Stocks,” Review of
Financial Studies 7, 539-573.

Breeden, D., Gibbons, M., and Litzenberger, R. (1989), “Empirical Tests of

the Consumption-Oriented CAPM,” Journal of Finance 44, 231-262.

Brown, S., and J. Warner (1985), “Using Daily Stock Return,” Journal of
Financial Economics 14, 3-31.

Campbell, J. (1991), “A Variance Decomposition for Stock Returns,”

Economic Journal 101, 157-79.

Campbell, John Y., and Shiller, Robert J. (1988), “Stock Prices, Earnings, and
Expected dividends,” Journal of Finance 43, 661-76.

Campbell, J., Cochrane, J. (1999), “By Force of Habit: A Consumption-based

Explanation of Aggregate Stock Market Behavior,” Journal of Political
Economy 107(2), 205-251.

Campbell, J., Cochrane, J. (2000), “Explaining the Poor Performance of

Consumption-based Asset Pricing Models,” Journal of Finance 55, 2863-78.

Campbell, J. Y., Lo, A. W., MacKinlay, A. C. (1997), The Econometrics of

Financial Markets, Princeton University Press, Princeton, NJ.

Cochrane, J. H. (2001), Asset Pricing, Princeton University Press, Princeton,

NJ.

Constantinides, G. (1990). “Habit Formation: A Resolution of the Equity

Premium Puzzle,” Journal of Political Economy 98(3), 519-543.

Conrad, J. and Kaul, Gautam (1988), “Time-Variation in Expected Return,”

Journal of Business 61, 409-425.
Engle, Robert (1982), “Autoregressive Conditional Heteroskedasticity with
Estimates of the Variance of UK Inflation,” Econometrica 50, 987-1008.

Epstein, L., Zin, S. (1991) “Substitution, Risk Aversion and the Temporal
Behavior of Consumption and Asset Returns: An Empirical Analysis,”
Journal of Political Economy 99, 263-286.

Fama, E., and French, K. (1988), “Permanent and Temporary Components of

Stock Prices,” Journal of Political Economy 96, 246-273.

Fama, E., and French, K. (1992), “The Cross-Section of Expected Stock

Returns,” Journal of Finance 47, 427-465.

Fama, E., and French, K. (1993), “Common Risk Factors in the Returns on
Stocks and Bonds,” Journal of Financial Economics 33, 3-56.

Fama, E. and J. MacBeth (1973), “Risk, Return and Equilibrium: Empirical

Tests,” Journal of Political Economy 81, 607-636.

Ferson, Wayne E., and Harvey, Campbell R. (1991), “The Variation of

Economic Risk Premiums,” Journal of Political Economy 99, 385-415.

Ferson, W., and Schadt, R. (1996), “Measuring Fund Strategy and

Performance in Changing Economic Conditions,” Journal of Finance 51, 425-
461.

Fleming, Jeff, Kirby, Chris, and Ostdiek, Barbara (2001), “The Econometric
Value of Volatility Timing,” Journal of Finance 56, 329-352.

Gibbons, M. R., Ross, S., Shanken, J. (1989), “A Test of the Efficiency of a

Given Portfolio,” Econometrica 57(5), 1121-1152.

Hansen, L. (1982), “Large Sample Properties of Generalized Method of

Moments Estimators,” Econometrica 50, 1029-1286.

Hansen, Lars Peter, and Jagannathan, Ravi (1991), “Implications of Security

Market Data for Models of Dynamic Economies,” Journal of Political
Economy 99 225-62.

Hansen, Lars Peter; Heaton, John; and Jagannathan, Ravi (1997), “Assesing
Specification Errors in Stochastic Discount Factor Models,” Journal of
Finance, 52(2), 557-590.

Hansen, L., Singleton, K. (1982), “Generalized Instrumental Variables

Estimation of Nonlinear Rational Expectations Models,” Econometrica 50,
1269-1286.

______, (1983), “Stochastic Consumption, Risk aversion, and the Temporal

Behavior of Asset Returns,” Journal of Political Economy.
Jagannathan, Ravi, and Z. Wang (1996), “The Conditional CAPM and the
Cross-Section of Expected Returns,” Journal of Finance, Vol. 51, 3-53

Kirby, Chris (1997), “Measuring the Predictable Variation in Stock and Bond
Returns,” Review of Financial Studies 10, 579-630.

Kocherlakota, Narayanna R. (1996), “The Equity Premium: It’s Still a

Puzzle,” Journal of Economic Literature 34, 42-71.

Kothari, S. P., Shanken, Jay, and Sloan, Richard G. (1995), “Another look at
the cross-section of expected stock returns,” Journal of Finance 50, 185-224.

Lewellen, Jonathan (2004), “Predicting Returns with Financial Ratios,”

Journal of Finance 74, 209-235.

Lo, A. W., and Mackinlay, A. C. (1988), “Stock Market Prices Do Not Follow
Random Walks: Evidence from a Simple Specification Test,” Review of
Financial Studies 1, 41-66.

Lucas, R. (1978), “Asset Prices in an Exchange Economy,” Econometrica 46,

1429-1445.

Mehra, R., Prescott, E. C. (1985) “The Equity Premium: A Puzzle,” Journal

of Monetary Economics 15, 145-161.

Nelson, Daniel B. (1991), “Conditional Heteroskedasticity in Asset Returns:

A New Approach,” Econometrica 59, 347-370.

Newey, Whitney K. and Kenneth D. West (1987), “A Simple, Positive Semi-

Definite, Heteroskedasticity and Autocorrelation Cinsistent Covariance
Matrix,” Econometrica 55, 703-708

Poterba, James, and Lawrence J. Summers (1988), “Mean Reversion in Stock

Prices: Evidence and Implications,” Journal of Financial Economics 22, 27-
59.

Richardson, Smith, (1994), “A Unified Approach to Testing for Serial

Correlation in Stock Returns,” Journal of Business 67(3), 371-399.

Roll, Richard R. (1977), “A Critique of the Asset Pricing Theory’s Tests: Part
I: On Past and Potential Testability of the Theory,” Journal of. Financial
Economics 4, 129-76.

Roll, Richard R., and Ross, Stephen A. (1980), “An Empirical Investigation
of the Arbitrage Pricing Theory,” Journal of Finance 35, 1073-1103.

Ross, Stephen A (1976), “The Arbitrage Theory of Capital Asset Pricing,”

Journal of Economic Theory 13, 341-60.

Tauchen, G., Pitts (1983), “The Price Variability-Volume Relationship on

Speculative Markets,” Econometrica 51(2), 485-506.
 Sharpe, William (1964), “Capital Asset Prices: A Theory of Market
Equilibrium under Conditions of Risk,” Journal of Finance 19, 425-42.

Weil, Philippe (1989), “The Equity Premium Puzzle and the Risk-Free Rate
Puzzle,” Journal of Monetary Economics 24, 401-421.

Course Policies
Problem Sets 30%
Grading (credit)
Criteria
Midterm Examination 30%
Final Examination 40%
Make-up Exams No make-up exams!
Extra CreditNo extra credit
Late Work Do not accept late homework in any circumstance
Special Assignments No
Not enforced but strongly encouraged. You will be responsible for all
Class Attendance
the materials discussed in class.
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Field Trip Policies N/A
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