University of Pennsylvania

The Wharton School

Professor Amir Yaron

Empirical Research in Finance FNCE-934, Spring 2006

O±ce: Steinberg-Dietrich Hall 2325

Phone: 215-898-1241

Fax: 215-898-6200

Email: yaron@wharton.upenn.edu

I. OBJECTIVES

This course is intended for PhD students in finance and related fields. It is designed to teach

students how to conduct empirical research in asset pricing. By the end of this semester,

students are expected to:

1. have a comprehensive conceptual framework of research in empirical asset pricing (i.e.,

be familiar with the issues at stake, the methodologies used, classic papers and recent

contributions to frontier topics).

2. be able to analyze and evaluate new research e±ciently; and

3. have acquired the skills to conduct and present original empirical research in ˉnance.

II. Prerequisite

To register for or audit FNCE 934 you must have completed FNCE 911 and FNCE 921, as

well as STAT 510 and STAT 511. In addition, you must have completed, or be currently

registered for FNCE 922.

III. Lectures and Exams

Lectures: Fridays SH-DH 109 1:00-4:00 PM

Final Exam: TBA

IV. Communication

Email is my main mode of communication. I will use email to send assignments and

administrative notices to all registered students. The o±cial information source for FNCE

934 is my course web site:

http://savage.wharton.upenn.edu/TEACHING/FNCE934.html

It holds all lecture notes and assignments that I have handed out to date. I will hand out a

V. Time Requirement

This is a very demanding course, irrespective of whether you are registered or just auditing.

The average student can expect to spend at least 20 hours per week outside of class with

assigned readings, problem sets, reviewing lectures, and working on the project.

VI. Grading and Auditing Privileges

The following components make up your course grade, if you are a registered student, or if

you are an auditing student:

2 Pre-Class Preparation:

To make this class work, everyone has to work through every assigned reading before

class. If you don't want to work hard, I don't want you in this class.

Registered Students: The first time I discover you did not work through an assigned

paper, I will issue you a warning. The second time, and every time thereafter, that I

discover you did not work through an assigned paper before class, I will deduct 1/3rd of

a grade from your final grade.

Auditing students: The first time I discover you did not work through the assigned

papers, I will issue you a warning. The second time, I will withdraw your auditing

privilege.

2 Assignments (25pts):

About every other week I will assign fairly lengthy homework. These assignments are

to be completed individually and be handed in at or before the beginning of class on

the day they are due. You should start working on the assignments as soon as possible.

Some of the assignments could take several days to complete. Under no circumstances

will I accept late homework.

The assignments are designed to help you understand the material, digest the assigned

papers that I do not cover in class, and familiarize yourself with empirical research.

Many problems will require the use of computers. You must know or quickly learn a

statistical programming language. I recommend that you use Matlab, Gauss, although

other software packages like SAS, RATS, or EVIEWS may work. Of course, you may be

a hard-core programmer and use C, C++, Fortran, or the more user friendly Fortan90.

2 Referee Reports & Presentation (25pts):

Most weeks that you are not working on an assignment, you will have to write a referee

report on a paper I will distribute in class. Each referee report should be no longer

than four pages, one-half spaced. Depending on the ultimate size of the class, I will

a) assign different papers to different students and b) require that students present an

executive summary of their report to the class on one of the papers marked as ? in the

reading list. The referee reports extend your knowledge of the literature and give you an

idea of the empirical and methodological questions current research focuses on. Perhaps

more important, they teach you to form an opinion about whether a piece of research is

outstanding or only mediocre. You will not be graded on whether your opinion agrees

with mine, but rather on how you come to your conclusions and how well you back them

up. It is quite possible that I will change my mind after reading your report.

Auditing students: You are required to hand in respectable referee reports, just like

registered students. If you do not, I will withdraw your auditing privilege.

2 Final Exam (25pts):

There will be a final examination (either three-hour in-class or 24-hour take-home). Since

life after graduate school is an open-book experience, you are allowed to bring in and use

any materials you like, as long as you are not disturbing other students. Any material

discussed in class or in the assigned readings (i.e. required readings) is fair game for the

exam. Auditing students: You are exempt from the exam.

2 Research Paper (25pts):

You will have to submit a semi-original research paper by June 1, 2004. Failure to submit

a paper by this dates will result in 0 points. I realize that this is not your thesis, so I do

not expect that you come up with a new methodology or attack an uncharted research

question. However, you should think of a paper topic that (a) uses a methodology

introduced in this course, or more advanced, to answer an empirical question of interest

to you and/or (b) improve on someones answer to an empirical question by refining a

methodology of interest to you. The paper should be no longer than 15 pages, one-

half spaced, not including tables and figures. I am more interested in seeing your mind

at work, than I am in reading a well polished piece research with extensive literature

review. Generally, I think the more clever your idea is, the shorter can the paper be.

In preparing your research proposal, you should choose a topic and bring yourself to

the frontier of the existing literature. You should search the recent finance journals for

related published papers and the SSRN or other sources for current working papers.

Auditing students: You are exempt from the research paper.

2 Participation:

I expect that you become an active participant in the class. You should ask questions,

raise issues, contribute your knowledge, and challenge the opinions of others, including

mine. This class will be a lot more enjoyable for everyone if you do. Auditing students:

You are required to participate, just like registered students. If you establish a reputation

for sitting quietly in the back-row, I may withdraw your auditing privilege.

VII. Texts & Readings

You should have access to the following books:

2 Campbell, J., A. Lo, and A.C. MacKinlay, 1997, The Econometrics of Financial Markets,

Princeton University Press.

2 Cochrane, J., 2001, Asset Pricing, Princeton University Press.

2 Hamilton, J., Time Series Analysis, Princeton University Press.

2 Judd Kenneth, Numerical Methods in Economics, The MIT Press.

Other books that you might find useful for this course are:

2 Du±e, D., Dynamic Asset Pricing Theory.

2 Gilks, W., S. Richardson, and D. Spiegelhalter, Markov Chain Monte Carlo in Practice.

2 Gourieroux, C., and J. Jasiak, 2001, Financial Econometrics: Problems, Models, and

Methods, Princeton University Press.

2 Judge, G., et al., The Theory and Practice of Econometrics.

2 Karlin, S., and H. Taylor, A First Course in Stochastic Processes.

2 Karlin, S., and H. Taylor, A Second Course in Stochastic Processes.

2 Ljungqvist, Lars, and Thomas J. Sargent, 2000, Recursive Macroeconomic Theory, The

MIT Press.

2 Marimon, Ramon, and Andrew Scott, 1999, Computational Methods for the Study of

Dynamic Economies, Oxford University Press.

2 Merton, R., Continuous-Time Finance.

2 Mills, T., The Econometric Modeling of Financial Time Series.

2 Sargent, T., Dynamic Macroeconomic Theory.

2 Silverman,B.W., Density Estimation for Statistical and Data Analysis.

2 Wooldridge, Jeffrey M., 2002, Econometric Analysis of Cross Section and Panel Data,

The MIT Press.

This course will evolve throughout the semester. Here is a preliminary reading list for the

semester.

The approach is to list important topical areas within the overall literature and a sample of

papers from each area. The choice of articles is a mix of classic papers and recent contributions

so that you can trace the evolution of the research in each area to the present. The lectures

will be devoted to discussing the genesis of important ideas in the literature and concurrent

developments that stimulated many of the ideas. I will also try to critically evaluate the

findings and research designs employed in past research. The main objective is to offer

competing hypotheses and interpretations for the observed findings, and to present unresolved

issues and directions for future research.

Contents

1 Preliminaries and Introduction 6

2 Time Varying Moments of Returns 6

2.1 Log-Linear Present Value Relation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2.2 Time-Series (Short-and Long-Horizon) Predictability . . . . . . . . . . . . . . . . . . 7

2.3 Volatility Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

2.4 Relation between Conditional Means and Variances . . . . . . . . . . . . . . . . . . . 8

3 Intertemporal Equilibrium Asset Pricing 9

3.1 Consumption-Based Asset Pricing { Representative Agent . . . . . . . . . . . . . . . 9

3.2 Financial Econometric Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

3.3 Production Based Asset Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

4 Heterogeneous Agents and Incomplete Markets 12

5 The Cross-Section of Returns 14

5.1 Cross-Sectional Expected Returns { ICAPM and Beta Method . . . . . . . . . . . . 14

5.2 Conditional Asset Pricing: SDF Method . . . . . . . . . . . . . . . . . . . . . . . . . 16

5.3 Production Based . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

5.4 Learning in Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

6 Fixed Income 18

6.1 Estimating and Testing Term Structure Models . . . . . . . . . . . . . . . . . . . . . 18

6.2 Estimating Continuous Time Processes . . . . . . . . . . . . . . . . . . . . . . . . . . 20

7 Contingent Claims 21

7.1 Option Pricing Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

7.2 Testing Option Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

7.3 Estimating Risk-Neutral Densities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

7.4 Estimating Real and Risk-Neutral Stock Price Dynamics . . . . . . . . . . . . . . . . 23

1 Preliminaries and Introduction

Required

1. Campbell, John Y., 2000, Asset Pricing at the Millennium, Journal of Finance, LV (4), 1515-

1567.

2. Hamilton, J., 1994, Time Series Analysis, Princeton University Press, Chapters 8,11,19.

Recommended

1. Cochrane, John H., 2005, Financial Markets and the Real Economy, NBER Working paper,

W11193.

2. Cochrane, John H., 1991, Volatility Tests and Efficient Markets, Journal of Monetary

Economics, 27, 463-485.

3. Cochrane, John H., 2001, Asset Pricing, Chapters 20 and 21

4. Constantinides, George M., 2002, Rational Asset Prices, Journal of Finance, LVII (4), 1567 -

1591.

5. Fama, Eugene, 1976, Foundations of Finance, Chapter 5.

6. Fama, Eugene F., 1991, Efficient Capital Markets: II, Journal of Finance, XLVI (5), 1575-

1617.

2 Time Varying Moments of Returns

2.1 Log-Linear Present Value Relation

Required

1. Campbell, J., and R. Shiller, 1988, The Dividend-Price Ratio and Expectations of Future

Dividends and Discount Factors, Review of Financial Studies 1, 195-228.

2. Campbell, J., and R. Shiller, 1987, Cointegration and Tests of Present Value Models, Journal

of Political Economy 95, 1062-1087.

Recommended

1. Campbell, J., 1991, A Variance Decomposition of Stock Returns, Economic Journal 101,

157-179.

2. Cochrane, J., 1988, How Big is the Random Walk in GNP?, Journal of Political Economy 96,

893-990.

3. Cochrane, John H., 1991, Volatility Tests and Efficient Markets, Journal of Monetary

Economics, 27, 463-485.

4. LeRoy, Stephen, and Richard Porter, 1981, The present value relation: Tests based on implied

variance bounds, Econometrica 49, 555{574.

2.2 Time-Series (Short-and Long-Horizon) Predictability

Required

1. Campbell, Lo, and MacKinlay, 1997, Chapter 7.

2. Cochrane John, "Explaining the Variance of Price-Dividend Ratios". Review of Financial

Studies 5:2, (June 1992) 243-280.

3. Hodrick, R., 1992, Dividend Yields and Expected Stock Returns: Alternative Procedures for

Inference and Measurement, Review of Financial Studies 5, 357- 386.

4. Stambaugh, Robert F., 1999, \Predictive Regressions", Journal of Financial Economics, 54,

375{421.

Recommended

1. ? Ang A. and Bekaert G. \Is Predictability there?", working paper, GSB, Columbia University.

2. Bansal Ravi and Amir Yaron "The Asset Pricing-Macro Nexus and Return-Cash Flow

Predictability", Working Paper, Wharton.

3. Fama, Eugene F., and Kenneth R. French, 1988a, Dividend Yields and Expected Stock

Returns, Journal of Financial Economics, 22, 3-25.

4. Fama, E., and K. French, 1988a, Permanent and Temporary Components of Stock Prices,

Journal of Political Economy, 96, 246-273.

5. Fama, E., and K. French, 1989, Business Conditions and Expected Returns on Stocks and

Bonds, Journal of Financial Economics 25, 23-49.

6. ? Lustig Hanno and Stijn Van Nieuwerburgh. The Returns on Human Capital: Good News

on Wall Street is Bad News on Main Street. Working Paper, NYU and UCLA.

7. Lamont, Owen, 1998, \Earnings and Expected Returns", Journal of Finance, 53, 1563 - 1587.

8. ? Lettau, M, and S. Ludvigson, 2001, Consumption, Aggregate Wealth, and Expected Stock

Returns, Journal of Finance 56, 815 - 850.

9. Lewellen, Jonathan W., 2004, Predicting Returns with Financial Ratios, Journal of Financial

Economics, 74 (2), 209-235.

10. Lo, A., 1991, Long Term Memory in Stock Market Prices, Econometrica 59, 1279- 1313.

11. Lo, Andrew W., and A. Craig MacKinlay, 1990, Data-Snooping Biases in Tests of Financial

Asset Pricing Models, Review of Financial Studies, 3, 431 - 468.

12. Poterba, J., and L. Summers, 1988, Mean Reversion in Stock Returns: Evidence and

Implications, Journal of Financial Economics 22, 27-60.

2.3 Volatility Models

Required

1. Bollerslev, T., 1986, Generalized Autoregressive Conditional Heteroscedasticity, Journal of

Econometrics 31, 307-327.

2. Bollerslev, T., R. Chou, and K. Kroner, 1992, ARCH Modeling in Finance: A Review of the

Theory and Empirical Evidence, Journal of Econometrics 52, 5-59.

3. Hamilton, J., 1989, A New Approach to the Economic Analysis of Nonstationary Time Series

and the Business Cycle, Econometrica 57, 357-384.

Speculative Prices, Econometrica 41, 135-156.

2. Engle, R., 1982, Autoregressive Conditional Heteroskedasticity with Estimates of the Variance

of U.K. In°ation, Econometrica 50, 987-1008.

3. Engle, R., V. Ng, and M. Rothschild, 1990, Asset Pricing with a Factor- ARCH Covariance

Structure: Empirical Estimates for Treasury Bills, Journal of Econometrics 45, 213-237.

4. Nelson, D., 1991, Conditional Heteroskedasticity in Asset Returns: A New Approach,

Econometrica 59, 347-370.

5. Pagan A., and G.W. Schwert, 1990, Alternative Models for Conditional Stock Volatility,

Journal of Econometrics 45, 267-290.

6. Schwert, G.W., 1989, Why Does Stock Market Volatility Change Over Time?, Journal of

Finance 44, 1115-1153.

2.4 Relation between Conditional Means and Variances

Required

1. Bollerslev, T., R. Engle, and J. Wooldridge, 1988, A Capital Asset Pricing Model with Time

Varying Covariance, Journal of Political Economy 96,116-131.

2. French, K., W. Schwert and R. Stambaugh, 1987, Expected Stock Returns and Volatility,

Journal of Financial Economics 19, 3-30.

3. Whitelaw, R., 1994, Time Variations and Covariations in the Expectation and Volatility of

Stock Market Returns, Journal of Finance 49, 515-541.

Recommended

1. Brandt, M., and Q. Kang, 2001, On the Contemporaneous and Intertemporal Relationship

between the Conditional Mean and Volatility of Stock Returns, Journal of Financial Economics,

72: 217-257

2. ? Campbell J. and Hentchell L. 1992, No News is Good News: A Asymmetric changing

Volatility in Stock Returns, Journal of Financial Economics 31, 281-318.

3. Harvey, C., 1989, Time Varying Conditional Covariance in Tests of Asset Pricing Models,

Journal of Financial Economics 24, 289-317.

4. ? Jagannathan, R., and Z.Wang, 1996, The Conditional CAPM and the Cross-Section of

Expected Returns, Journal of Finance 51, 3-53.

3 Intertemporal Equilibrium Asset Pricing

3.1 Consumption-Based Asset Pricing { Representative Agent

Required

1. Abel, Andrew B., 1990, Asset prices under habit formation and catching up with the Joneses,

American Economic Review 80, 38{42.

2. Bansal, Ravi, and Amir Yaron, 2004, \Risk for the Long Run: A Potential Resolution of

Asset Pricing Puzzles," Journal of Finance, 59(4), 1481-1509,

3. Campbell, John Y., and John H. Cochrane, 1999, By Force of Habit: A Consumption-Based

Explanation of Aggregate Stock Market Behavior, Journal of Political Economy, 107, 205 -

251.

4. Constantinides, G., 1990, Habit Formation: A Resolution of the Equity Premium Puzzle,

Journal of Political Economy 98, 519 { 543.

5. Epstein, L., and S. Zin, 1989, Substitution, Risk Aversion, and the Temporal Behavior of

Consumption and Asset Returns: An Empirical Analysis, Journal of Political Economy 99,

263-286.

6. Hansen, L.P., and R. Jagannathan, 1991, Implications of Security Market Data for Models of

Dynamic Economies, Journal of Political Economy 99, 225 { 262.

7. Hansen, L.P., and K. Singleton, 1982, Generalized Instrumental Variables Estimation of

Nonlinear Rational Expectation Models, Econometrica 50, 1269 { 1286.

8. Lucas Robert Jr., 1978, "Asset Prices in an Exchange Economy", Econometrica, 46, 1429-

1446.

9. Mehra, R., and E. Prescott, 1985, The Equity Premium: A Puzzle, Journal of Monetary

Economics 15, 145 { 161.

Recommended

1. Abel, Andrew B., 1999, Risk premia and term premia in general equilibrium, Journal of

Monetary Economics 43, 3{33.

2. Campbell, John Y., 2002, Consumption-Based Asset Pricing, forthcoming, Handbook of the

Economics of Finance, Edited by George Constantinides, Milton Harris, and Rene Stulz,

North-Holland.

3. Bansal Ravi, Khatachtarian Varoujan, and Amir Yaron, "Interpretable Asset Markets?",

European Economic Review. 49, April 2005: 531-560.

4. Bansal, Ravi, and Wilbur J. Coleman II, 1997, A monetary explanation of the equity premium,

term premium and the risk-free rate puzzles, Journal of Political Economy, 104, 1135{1171.

5. Breeden, Douglas, Michael Gibbons, and Robert Litzenberger, 1989, Empirical Tests of the

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

6. Brown, D., and M. Gibbons, 1985, A Simple Econometric Approach for Utility-Based Asset

Pricing Models, Journal of Finance 40, 359 { 381.

7. Campbell, John Y., and John H. Cochrane, 2000, Explaining the Poor Performance of

Consumption-based Asset Pricing Models, Journal of Finance, LV (6), 2863 - 2878.

8. Campbell, J., 1993, Intertemporal Asset Pricing without Consumption Data, American

Economic Review 83, 487 { 512.

9. Campbell, Lo, and MacKinlay, 1997, Chapter 8.

10. Cecchetti, Stephen G., Pok-Sang Lam, and Nelson C. Mark, 1990, Mean reversion in

equilibrium asset prices, American Economic Review 80, 398{419

11. Cochrane, John H., and Lars P. Hansen, 1992, Asset Pricing Explorations for

Macroeconomics, NBER Macroeconomic Annual, 115 - 165.

12. Ferson, Wayne E., and George M. Constantinides, 1991, Habit Persistence and Durability in

Aggregate Consumption: Empirical Tests, Journal of Financial Economics, 29, 199 - 240.

13. Hansen, Lars Peter, and Kenneth J. Singleton, 1982, Generalized Instrumental Variables

Estimation of Nonlinear Rational Expectations Models, Econometrica, 50, 1269-1288.

14. ? Hansen Lars Peter, John Heaton, and Nan Li. Consumption Strikes Back?, Working Paper,

University of Chicago.

15. Heaton, J., 1995, An Empirical Investigation of Asset Pricing with Temporally Dependent

Preference Specifications, Econometrica 63, 681 { 718.

16. Hansen, L.P., and R. Jagannathan, 1997, Assessing Specification Errors in Stochastic Discount

Factor Models, Journal of Finance 52, 557-590.

17. Hansen, L.P., and K. Singleton, 1983, Stochastic Consumption, Risk Aversion and the

Temporal Behavior of Asset Returns, Journal of Political Economy 91, 249 { 268.

18. Hansen, L.P., and K. Singleton, 1984, Errata, Econometrica 52, 267 { 268.

19. Kandel, Shmuel, and Robert F. Stambaugh, 1991, Asset returns and intertemporal

preferences, Journal of Monetary Economics 27, 39{71.

20. Weil, P., 1989 The Equity Premium Puzzle and the Risk-Free Rate Puzzle, Journal of

Monetary Economics 24, 401 { 421.

3.2 Financial Econometric Methods

Required

1. Gallant, R., and G. Tauchen, 1996, Which Moments to Match, Econometric Theory 12, 657{

681.

2. Hansen, L.P., 1982, Large Sample Properties of Generalized Method of Moments Estimators,

Econometrica 50, 1029{1054.

3. Lee, B., and B. Ingram, 1991, Simulation Estimation of Time-Series Models, Journal of

Econometrics 47, 197{205.

4. Ogaki, M., 1993, Generalized Method of Moments: Econometric Applications, in Handbook

of Statistics, Vol. 11.

5. Tauchen G. and R. Hussey, 1991, "Quadrature-Based Methods for Obtaining Approximate

Solutions to Nonlinear Asset Pricing Models," Econometrica, Volume 59, No. 2, pp. 371{396.

Recommended

1. Du±e, D., and K. Singleton, 1993, Simulated Moments Estimation of Markov Models of Asset

Prices, Econometrica 61:4, 929-952.

2. Gallant, R., and D. Nychka, 1987, Seminonparametric Maximum Likelihood Estimation,

Econometrica 55, 363-390.

3. Gallant, R., and G. Tauchen, 1989, Seminonparametric Estimation of Conditionally

Constrained Heterogeneous Processes: Asset Pricing Applications, Econometrica 57, 1091-

1120.

4. Hansen, Lars Peter, and James H. Heckman, 1996, The Empirical Foundations of Calibration,

Journal of Economic Perspective, 10 (1), 87 - 104.

5. Hansen, L.P., J. Heaton, and A. Yaron, 1996, Finite Sample Properties of Some Alternative

GMM Estimators, Journal of Business and Economic Statistics 14, 262 { 280.

3.3 Production Based Asset Pricing

Required

1. Cochrane, J., 1991, Production-Based Asset Pricing and the Link between Stock Returns and

Economic Fluctuations, Journal of Finance 46, 209-234.

2. Jermann, Urban J., 1998, Asset Pricing in Production Economies, Journal of Monetary

Economics, 41, 257 - 275.

Recommended

1. Boldrin, Michele, Larry Christiano, and Jonas Fisher, 2001, Habit Persistence, Asset Returns,

and the Business Cycle, American Economic Review, 91 (1), 149 - 166.

2. Chen, Nai-Fu, 1991, Financial Investment Opportunities and the Macroeconomy, Journal of

Finance, 46, 2, 529 - 554.

3. Fama, Eugene, F., 1990, Stock Returns, Expected Returns, and Real Activity, Journal of

Finance, 45, 1089 - 1108.

4. Gomes, Joao F., Amir Yaron, and Lu Zhang, 2002a, Asset Prices and Business Cycles with

Costly External Finance, Review of Economic Dynamics, Forthcoming.

5. Hall, Robert E., 2001, The Stock Market and Capital Accumulation, American Economic

Review, 91 (5), 1185 - 1202.

6. Lettau, Martin, and Sydney Ludvigson, 2002, Time-Varying Risk Premia and the Cost of

Capital: An Alternative Implication of the Q Theory of Investment, Journal of Monetary

Economics, 49, 31 - 66.

7. ? Lamont, Owen A., 2000, Investment Plans and Stock Returns, Journal of Finance, LV (6),

2719 - 2745.

8. ? McGrattan, Ellen, and Edward C. Prescott, 2001b, Taxes, Regulations, and Asset Prices,

NBER Working Paper, NO. w8623.

9. Rouwenhorst, G., 1995, Asset Pricing Implications of Equilibrium Business Cycle Models, in

Frontiers of Business Cycle Research, T. Cooley, Ed., Princeton University Press, Princeton,

NJ.

4 Heterogeneous Agents and Incomplete Markets

Required

1. Alvarez F. and U. Jermann, " Quantitative asset pricing implications of endogenous solvency

constraints." Review of Financial Studies 14 (November 2001): 1117 { 52.

2. Constantinides, G., and D. Du±e, 1996, Asset Pricing with Heterogenous Consumers, Journal

of Political Economy 104, 219-240.

3. Heaton J. and D. Lucas, 1996, "Evaluating the Effects of Incomplete Markets on Risk Sharing

and Asset Pricing," Journal of Political Economy, 104, 443-487.

4. Krusell P. and T. Smith, 1998, "Income andWealth Heterogeneity in Macroeconomy," Journal

of Political Economy, 106, 867-896.

5. Mankiw, Gregory N. 1986, The equity premium and the concentration of aggregate shocks.

Journal of Financial Economics 17, September, 211{219.

Recommended

1. Basak S. and D. Cuoco, 1998, "An Equilibrium Model with Restricted Stock Market

Participation." Review of Financial Studies 309-341.

2. Brav Alon; Constantinides M., George; and Chris, Christopher C. "Asset pricing with

heterogeneous consumers and limited participation: Empirical evidence." Journal of Political

Economy 110 (August 2002): 793{824.

3. Chan, Lewis, and Leonid Kogan, 2002, Catching Up with the Jones: Heterogeneous

Preferences and the Dynamics of Asset Prices, Journal of Political Economy, 110, 1255-1285

4. ? Constantinides G., Donaladson G. and R. Mehra, 2002, "Juniors Can't Borrow: A New

Perspective on the Equity Premium Puzzle", Quarterly Journal of Economics.

5. Den Haan, W.J., 2001, Understanding Equilibrium Models with a small and a Large Number

of Agents, Journal of Economic Dynamics and Control , 25(5), 721 { 746.

6. Den Haan, W.J., 1997, Solving Dynamic Models with Aggregate Shocks and Heterogeneous

Agents. Macroeconomic Dynamics , 1(2), 355 { 386.

7. Den Haan, W.J., 1996, Heterogeneity, aggregate uncertainty and the short term interest rate,

Journal of Business and Economic Statistics, , 14(4) 399 { 411.

8. ? Guvenen, Fatih, 2002, A Parsimonious Macroeconomic Model for Asset Pricing: Habit

Formation or Cross-sectional Heterogeneity? Working Paper, University of Rochester.

9. Heaton J. and D. Lucas, 1992, "The Effects of Incomplete Insurance Markets and Trading

Costs in a Consumption-Based Asset Pricing Model" Journal of Economic Dynamics and

Control.16, 601-620

10. Huggett Mark, 1993, The Risk Free Rate in Heterogeneous-Agents, Incomplete Insurance

Economies, Journal of Economic Dynamics and Control, 17, 953-969.

11. Krusell, Per, and Smith, Anthony A. Income and wealth heterogeneity, portfolio choice, and

equilibrium asset returns." Macroeconomic Dynamics 1 (June 1997): 387-422.

12. Lucas, Deborah J. Asset pricing with undiversifiable risk and short sales constraints:

Deepening the equity premium puzzle, Journal of Monetary Economics 34 (December 1994):

325-41.

13. ? Lustig, Hanno. The market price of aggregate risk and the wealth distribution." Manuscript,

Stanford University, 2001.

14. ? Lustig Hanno and Stijn Van Nieuwerburgh. 2005, Housing Collateral, Consumption Insurance

and Risk Premia: an Empirical Perspective, Journal of Finance, Vol. 60 (3), pp.1167-1219

15. ? Lustig Hanno and Stijn Van Nieuwerburgh. Quantitative Asset Pricing Implications of

Housing Collateral Constraint, Working Paper NYU and UCLA.

16. Telmer Chris, 1993, Asset Pricing Puzzles and Incomplete Markets, Journal of Finance, 48,

1803-1832.

17. Storesletten, Kjetil; Telmer, Chris I.; and Yaron, Amir, 2000, Asset pricing with idiosyncratic

risk and overlapping generations." Manuscript, Carnegie Mellon University,

18. Storesletten, Kjetil; Telmer, Chris I.; and Yaron, Amir. Consumption and risk sharing over

the life cycle," Journal of Monetary Economics, 2004, 51: 609-633.

19. Storesletten, Kjetil; Telmer, Chris I.; and Yaron, Amir. Cyclical Dynamics of Idiosyncratic

Labor Market Risk," Forthcoming Journal of Political Economy, 2004, 112:3 695-717.

20. Vissing-Jorgensen, Annette, 2002, Limited asset market participation and the elasticity of

intertemporal substitution, Journal of Political Economy 110, 825 { 853.

21. Zhang Harold, 1997, Endogenous Borrowing Constraints with Incomplete Markets, Journal of

Finance, 52(5), 2187 { 2209.

5 The Cross-Section of Returns

5.1 Cross-Sectional Expected Returns { ICAPM and Beta Method

Required

1. Bansal R. Dittmar R. and C. Lundblad "Consumption, Dividends, and the Cross-Section of

Equity Returns," Working Paper, Fuqua, Duke University.

2. Campbell, Lo, and MacKinlay, 1997, Chapter 5 and 6.

3. Fama, Eugene F., and Kenneth R. French, 1992, The Cross-Section of Expected Stock

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

4. Fama, Eugene F., and Kenneth R. French, 1995, Size and Book-to-Market Factors in Earnings

and Returns, Journal of Finance, 50, 131-155.

5. Fama, Eugene F., and Kenneth R. French, 1996, Multifactor Explanations of Asset Pricing

Anomalies, Journal of Finance, 51, 55-84.

6. Gibbons, Michael R., Stephen A. Ross, and Jay Shanken, 1989, A Test of the E±ciency of a

Given Portfolio, Econometrica, 57, 1121-1152.

7. Jagannathan, Ravi, and Zhenyu Wang, 1996, The Conditional CAPM and the Cross-Section

of Expected Returns, Journal of Finance, 51, 3-54.

8. Lettau, Martin, and Sydney Ludvigson, 2001, Resurrecting the (C)CAPM: A Cross-Sectional

Test When Risk Premia Are Time-Varying, Journal of Political Economy, 109 (6), 1238-1287.

9. Menzly Lior, Tano Santos, Pietro Veronesi, 2004, The Time Series of the Cross Section of

Asset Prices(understanding predictability), Journal of Political Economy. 112:1, 1:47

Recommended

1. Ball, Ray, S.P. Kothari, and Jay Shanken, 1995, Problems in Measuring Portfolio

Performance: An Application to Contrarian Investment Strategies, Journal of Financial

Economics, (38), 79-107.

2. Bansal Ravi, Ed Fang, Amir Yaron, 2005, Equity Capital: A Puzzle?, Working Paper,

Wharton.

3. ? Berk, Jonathan, 1995, A Critique of Size-Related Anomalies, Review of Financial Studies,

8, 275-286.

4. Berk, Jonnathan, 2000, Sorting out Sorts, Journal of Finance, 55 (1), 407-427.

5. Brennan, Michael, Tarun Chordia, and Avanidhar Subrahmanyam, 1998, Alternative Factor

Specifications, Security Characteristics, and the Cross-Section of Expected Stock Returns,

Journal of Financial Economics, 49, 345-373.

6. Brennan, Michael, Yihong Xia, and Ashley Wang, 2002, Intertemporal Capital Asset Pricing

and the Fama-French Three-Factor Model, Working Paper, UCLA.

7. Campbell, John Y., 1996, Understanding Risk and Return, Journal of Political Economy, 104,

298-345.

8. ? Campbell, John and Vuolteenaho, Tuomo, 2004, Bad Beta, Good Beta. American Economic

Review 94:1249-1275.

9. Cohen, Randolph B., Christopher Polk, and Tuomo Vuolteenaho, 2002, The Value Spread,

Forthcoming, Journal of Finance.

10. Chen, Nai-Fu, Richard Roll, and Stephen Ross, 1986, Economic Forces and the Stock Market,

Journal of Business, 59, 3, 383-403.

11. ? Daniel, Kent, and Sheridan Titman, 1997, Evidence on the Characteristics of Cross Sectional

Variation in Stock Returns, Journal of Finance, 52(1), 1-33.

12. Davis, James L., Eugene F. Fama, and Kenneth R. French, 2000, Characteristics, Covariances,

and Average Returns: 1929-1997, Journal of Finance 55 (1), 389-406.

13. Fama, Eugene F., and Kenneth R. French, 1993, Common Risk Factors in the Returns on

Bonds and Stocks, Journal of Financial Economics, 33, 3-56.

14. Fama, Eugene F., and Kenneth R. French, 1999, Value Versus Growth: The International

Evidence, Journal of Finance, 53 (6), 1975-1999.

15. Kothari, S.P., Jay Shanken, and Richard Sloan, 1995, Another Look at the Cross-Section of

Expected Returns, Journal of Finance, 50, 185-224.

16. Lakonishok, Josef, Andrei Shleifer, and Robert W. Vishny, 1994, Contrarian Investment,

Extrapolation, and Risk, Journal of Finance, XLIX (5), 1541-1578.

17. LaPorta, Rafael, Josef Lakonishok, Andrei Shleifer, and Robert Vishny, 1997, Good News for

Value Stocks: Further Evidence on Market E±ciency, Journal of Finance, 52 (2), 859-874.

18. ? Jonathan Lewellen, and Stefan Nagel, The Conditional CAPM Does Not Explain Asset

Pricing Anomalies , Journal of Financial Economics, forthcoming.

19. Moskowitz Tobias, Chris Malloy, Annette Vising-Jorgensen, long run consumption risk of

stockholders, working paper, University of Chicago.

20. Liew, Jimmy, and Maria Vassalou, 2000, Can Book-to-Market, Size, and Momentum Be Risk

Factors That Predict Economic Growth? Journal of Financial Economics, 57, 221-245.

21. MacKinlay, A. Craig, 1995, Multifactor Models Do Not Explain Deviations From The CAPM,

Journal of Financial Economics, 38, 3-28.

22. ? Tano Santos, Pietro Veronesi, 2005 Cash Flow Risk, Discount Risk, and the Value Premium,

working paper, University of Chicago.

23. Shanken, Jay, 1992, On the Estimation of Beta-Pricing Models, Review of Financial Studies,

5 (1). 1:33

24. Vuolteenaho, Tuomo, 2001, What Drives Firm-Level Stock Returns? Journal of Finance, 57

(1), 233-264.

5.2 Conditional Asset Pricing: SDF Method

Required

1. Bansal, Ravi and Viswanathan, S. (1993), No-arbitrage and and arbitrage pricing: A new

approach", Journal of Finance 48, 1231 { 1262.

2. Cochrane, John, 2001, Asset Pricing, Chapters 10-16.

3. Hansen, L.P., and S. Richard, 1987, The Role of Conditioning Information in Deducing

Testable Restrictions Implied by Dynamic Asset Pricing Models, Econometrica 55, 587 {

613.

4. Jagannathan, Ravi and ZhenyuWang, 1998, An asymptotic theory for estimating beta-pricing

models using cross-sectional regressions, Journal of Finance 53, 1285 { 1309.

5. Jagannathan, Ravi and Zhenyu Wang, 2002, Empirical evaluation of asset pricing models: A

comparison of the SDF and Beta methods, Journal of Finance 57, 2337 { 2367.

Recommended

1. Ball Ray, and S. P. Kothari, 1989, Nonstationary Expected Returns: Implications for Tests

of Market E±ciency and Serial Correlation in Returns, Journal of Financial Economics, 25,

51-74.

2. Chan, K. C., and Nai-Fu Chen, 1988, An Unconditional Asset-Pricing Test and the Role of

Firm Size as an Instrumental Variable for Risk, Journal of Finance, 43, 2, 309-325.

3. Chan, Louis K. C., and Nai-fu Chen, 1991, Structural and Return Characteristics of Small

and Large Firms, Journal of Finance, 46, 1467-1484.

4. Ferson, Wayne E., and Campbell R. Harvey, 1999, Conditioning Variables And Cross-Section

of Stock Returns, Journal of Finance, 54, 1325-1360.

5. Ferson, Wayne E., 2002, Tests of Multifactor Pricing Models, Volatility Bounds, and Portfolio

Performance, forthcoming, in Handbook of the Economics of Finance, Edited by George

Constantinides, Milton Harris, and Rene Stulz, North-Holland.

6. Ferson Wayne, and Campbell R. Harvey, 1991, The Variation of Economic Risk Premiums,

Journal of Political Economy, 99, 385-415.

7. Lewellen, Jonathan, 1999, The Time-Series Relations Among Expected Return, Risk, and

Book-to-Market, Journal of Financial Economics, 54, 5-43.

8. Shanken, Jay, 1990, Intertemporal Asset Pricing: An Empirical Investigation, Journal of

Econometrics, 45, 99-120.

5.3 Production Based

Required

1. Berk, Jonathan B, Richard C. Green and Vasant Naik, 1999, Optimal Investment, Growth

Options and Security Returns, Journal of Finance, 54, 1553 - 1607.

2. Cochrane, John H., 1996, A Cross-Sectional Test of an Investment-Based Asset Pricing Model,

Journal of Political Economy, 104 (3), 572 - 621.

Recommended

1. ? Dow, James, Gary Gorton, and Arvind Krishnamurthy, 2002, Corporate Finance and

the Term Structure of Interest Rates, Working Paper, Kellogg School of Management,

Northwestern University.

2. ? Gomes, Joao F., Leonid Kogan, and Lu Zhang, 2003, Equilibrium Cross-Section of Returns,

Journal of Political Economy, 111:4, 693-732

3. Gomes, Joao F., Amir Yaron, and Lu Zhang, 2002b, Asset Pricing Implications of Firms

Financing Constraints, Working Paper, The Wharton School, University of Pennsylvania.

4. ? Johnson, Timothy, 2002, Rational Momentum Effect, Journal of Finance, LVII (2), 585-608.

5. Leahy, John V., and Toni M. Whited, 1996, The Effect of Uncertainty on Investment: Some

Stylized Facts, Journal of Money, Credit, and Banking, 28 (1), 64-83.

6. Vassalou, Maria, and Yuhang Xing, 2002, Default Risk in Equity Returns, Working Paper,

Columbia Businss School.

7. Zhang, Lu, 2005, The Value Premium, Journal of Finance: LX:1 67-108

5.4 Learning in Capital Markets

Required

1. Brav, Alon, and J.B. Heaton, 2002, Competing Theories of Financial Anomalies, Review of

Financial Studies, 15 (2), 575-606.

2. Lewellen, Jonathan, and Jay Shanken, 2002, Learning, Asset-Pricing Tests, and Market

E±ciency, Journal of Finance, LVII (3), 1113-1145.

3. Pastor, Lubos, and Petro Veronesi, 2003, Learning About Profitability, Journal of Finance,

LVIII:4 1749-1789.

4. Pastor Lubos and Pietro Veronesi, 2005, Technological Revolutions and Stock Prices.

5. Timmermann, Allan, 1996, Excess volatility and predictability of stock returns in

autoregressive dividend models with learning, Review of Economic Studies 63, 523- 527.

Recommended

1. Brandt, Michael, Qi Zeng, and Lu Zhang, 2004, Equilibrium Stock Return Dynamics

Under Alternative Rules of Learning About Hidden State, Journal of Economic

Dynamics and Control, 28, 1925-1954

6 Fixed Income

6.1 Estimating and Testing Term Structure Models

Required

1. Backus D., and S. Foresi, and C. Telmer, 1999, Discrete Time Models of Bond Pricing, in N.

Jegadeesh and B. Tuckman, eds., Advanced Fixed-Income Valuation, Wiley and Sons.

2. Campbell, Lo, and MacKinlay, 1997, Chapters 10 an 11.

3. Cox, J., J. Ingersoll, and S. Ross, 1985, A Theory of the Term Structure of Interest Rate,

Econometrica 53, 385-407.

4. Dai Q. and K. Singleton, 2003, "Term Structure Modeling in Theory and Reality," Review

of Financial Studies . Vol. 16, 631-678.

5. Gibbons, M., and K. Ramaswamy, 1993, A Test of the Cox, Ingersoll, and Ross Model of the

Term Structure, Review of Financial Studies 6, 619-658.

6. Gray, S., 1996, Modeling the Conditional Distribution of Interest Rates as a Regime-Switching

Process, Journal of Financial Economics 42, 27-62.

7. Stambaugh, R., 1988, The Information in Forward Rates: Implications for Models of the

Term Structure, Journal of Financial Economics 21, 41-70.

8. Vasicek, O., 1977, An Equilibrium Characterization of the Term Structure, Journal of

Financial Economics 5, 177-188.

Recommended

1. Ang, Andrew, and Monika Piazzesi, 2003, A No-Arbitrage Vector Autoregression of Term

Structure Dynamics with Macroeconomic and Latent Variables, Journal of Monetary

Economics, 50(4), 745-787

2. ? Bansal, R. and H. Zhou (2002). Term Structure of Interest Rates with Regime Shifts.

Journal of Finance 57, 1997-2043.

3. Bekaert, Geert, Robert J. Hodrick, and David A. Marshall, 1997, On Biases in Tests of

the Expectation Hypothesis of the Term Structure of Interest Rates, Journal of Financial

Economics, 44, 309-348.

4. Black, F., E. Derman, and W. Toy, 1990, A One-Factor Model of Interest Rates and its

Application to Treasury Bond Options, Financial Analysts Journal, January- February, 33-

39.

5. Brown, S., and P. Dybvig, 1986, The Empirical Implications of the Cox, Ingersoll, Ross

Theory of the Term Structure of Interest Rates, Journal of Finance 41, 617- 632.

6. Campbell, J., 1987, Stock Market and the Term Structure, Journal of Financial Economics

18, 373-399.

7. Campbell, John Y., and Robert J. Shiller, 1991, Yield Spreads and Interest Rates: A Birds

Eye View, Review of Economic Studies, 58, 495-514.

8. Chan, K., A. Karolyi, F. Longstaff, and A. Sanders, 1992, An Empirical Comparison of

Alternative Models of the Short-term Interest Rate, Journal of Finance 47, 1209-1228.

9. ? Cochrane, John, and Monika Piazzesi, 2004, Bond Risk Premia, forthcoming, American

Economic Review.

10. Constantinides, G., 1992, A Theory of the Nominal Term Structure of Interest Rates, Review

of Financial Studies 5, 531-552.

11. ? Dai Q. and K. Singleton, 2000, "Analysis of A±ne Term Structure Models," Journal of

Finance, Vol. LV, 1943-1978.

12. Du±e, D., and R. Kan, 1996, A Yield-Factor Model of Interest Rates, Mathematical Finance

6, 379-406.

13. Fama, E., 1984, The Information in the Term Structure, Journal of Financial Economics 13,

509-528.

14. Fama, Eugene F., and Robert R. Bliss, 1987, The Information in Long-Maturity Forward

Rates, American Economic Review, 77, 680-692.

15. ? Heath, D., R. Jarrow, and A. Merton, 1992, Bond Pricing and the Term Structure of Interest

Rates: A New Methodology for Contigent Claims Valuation, Econometrica 60, 77-105.

16. Heath, D., R. Jarrow, and A. Merton, 1990, Bond Pricing and the Term Structure of Interest

Rates: A Discrete Time Approximation, Journal of Financial and Quantitative Analysis 25,

419-440.

17. ? Ho, T., and S. Lee, 1986, Term Structure Movements and Pricing Interest Rate Contingent

Claims, Journal of Finance 41, 1011-1029.

18. Hull, J., and A. White, 1990, Pricing Interest-Rate-Derivative Securities, Review of Financial

Studies 3, 573-592.

19. Knez, P., R. Litterman, and J. Scheinkman, 1994, Explorations into Factors Explaining Money

Market Returns, Journal of Finance 49, 1861-1882.

20. Longstaff, F., and E. Schwartz, 1992, Interest Rate Volatility and the Term Structure: A

Two-Factor General Equilibrium Model, Journal of Finance 47, 1259- 1282.

21. Pearson, N., and T. Sun, 1994, Exploiting the Conditional Density in Estimating the Term

Structure: An Application to the Cox, Ingersoll and Ross Model, Journal of Finance 49,

1279-1304.

22. Piazzesi, M. (2001). An Econometric Model of the Term Structure with Macroeconomic Jump

Effects. Working Paper, UCLA.

23. Sun, T., 1992, Real and Nominal Interest Rates: A Discrete Time Model and Its Continuous

Time Limit, Review of Financial Studies 21, 41-70.

6.2 Estimating Continuous Time Processes

Required

1. Ait-Sahalia, Y., 1996c, Testing Continuous Time Models of the Spot Interest Rate, Review

of Financial Studies 9, 385-426.

2. Ait-Sahalia, Y., 2002, Maximum Likelihood Estimation of Discretely Sampled Diffusion: A

Closed Form Approach, Econometrica, 70: 1, 223-262.

3. Andersen, T., and J. Lund, 1997a, Estimating Continuous Time Stochastic Volatility Models

of the Short Term Interest Rate, Journal of Econometrics 77, 343-378.

4. Brandt, M., and P. Santa-Clara, 2002, Simulated Likelihood Estimation of Multivariate

Diffusion with an Application to the Exchange Rate Dynamics in Incomplete Markets,

Journal of Financial Economics, 63, 161-210

5. Chapman, D., and N. Pearson, 2000, Is the Short Rate Drift Actually Nonlinear? Journal of

Finance 55, 355-388.

6. Pritsker, M., 1998, Nonparametric Density Estimation and Tests of Continuous Time Interest

Rate Models, Review of Financial Studies 11, 449-487.

7. Stanton, R., 1997, A Nonparametric Model of Term Structure Dynamics and the Market

Price of Interest Rate Risk, Journal of Finance 52, 1973-2002.

Model is a Diffusion, Journal of Finance. 57(5), 2075-2112

2. Ait-Sahalia, Y., 1996, Nonparametric Pricing of Interest Rate Derivative Securities,

Econometrica 64, 527-560.

3. Conley, T., L.P. Hansen, E. Luttmer, and J. Scheinkman, 1997, Short-Term Interest Rates as

Subordinated Diffusions, Review of Financial Studies 10, 525-578.

4. Gallant, R., and G. Tauchen, 1998, Reprojecting Partially Observed Systems with Application

to Interest Rate Diffusions, Journal of the American Statistical Association 93, 10-24.

5. Gourieroux, C., A. Monfort, and E. Renault, 1993, Indirect Inference, Journal of Applied

Econometrics 8, S85-S118.

6. Hansen, L.P., and J. Scheinkman, 1995, Back to the Future: Generating Moment Implications

for Continuous Time Markov Processes, Econometrica 63, 767-804.

7. Hansen, L.P., J. Scheinkman, and N. Touzi, 1997, Spectral Methods for Identifying Scalar

Diffusions, Journal of Econometrics 86, 1-32.

8. Jiang, G., and J. Knight, 1997, A Nonparametric Approach to the Estimation of Diffusion

Processes, with an Application to a Short-Term Interest Rate Model, Econometric Theory

13, 615-645.

9. Lo, A., 1988, Maximum Likelihood Estimation of Generalized Ito Processes with Discretely

Sampled Data, Econometric Theory 4, 231-247.

10. Merton, R., 1980, On Estimating the Expected Return on the Market, Journal of Financial

Economics 8, 323-362.

11. Pedersen, A., 1995, A New Approach to Maximum Likelihood Estimation for Stochastic

Differential Equations Based on Discrete Observations, Scandinavian Journal of Statistics 22,

55-71.

7 Contingent Claims

7.1 Option Pricing Basics

Required

1. Black, F., and M. Scholes, 1973, The Valuation of Option and Corporate Liabilities, Journal

of Political Economy 81, 637-654.

2. Hull, J., and A. White, 1987, The Pricing of Options on Assets with Stochastic Volatilities,

Journal of Finance 42, 281-300.

3. Lo, A., and J. Wang, 1995, Implementing Option Pricing Models when Asset Returns are

Predictable, Journal of Finance 50, 87-129.

4. Cox, J., S. Ross, and M. Rubinstein, 1979, Option Pricing: A Simplified Approach, Journal

of Financial Economics 7, 229-263.

5. French, K., and R. Roll, 1986, Stock Return Variances: The Arrival of Information and the

Reaction of Traders, Journal of Financial Economics 17, 5-26.

6. Merton, R., 1976a, The Impact on Option Pricing of Specification Error in the Underlying

Stock Price Distribution, Journal of Finance 31, 333-350.

7. Merton, R., 1976b, Option Pricing When Underlying Stock Returns are Discontinuous,

Journal of Financial Economics 3, 125-144.

8. Whaley, R., 1982, Valuation of American Call Options on Dividend-Paying Stocks: Empirical

Tests, Journal of Financial Economics 10, 29-58.

9. Wiggins, J., 1987, Option Values Under Stochastic Volatility: Theory and Empirical

Estimates, Journal of Financial Economics 19, 351-372.

7.2 Testing Option Pricing Models

Required

1. Bakshi, G., C. Cao, and Z. Chen, 1997b, Empirical Performance of Alternative Option Pricing

Models, Journal of Finance 52, 2003-2049.

2. Bakshi, G., C. Cao, and Z. Chen, 2000, Do Call Prices and the Underlying Stock Always

Move in the Same Direction?, Review of Financial Studies 13, 549-584.

3. Burashi, A., and J. Jackwerth, 2001, The Price of a Smile: Hedging and Spanning in Option

Markets, Review of Financial Studies 14, 495-528.

4. Coval, J., and T. Shumway, 2001, Expected Option Returns, Journal of Finance 56, 983-1009.

5. Christensen, B., and N. Prabhala, 1998, The Relation between Implied and Realized Volatility,

Journal of Financial Economics 50, 125-50.

6. Rubinstein, M., 1985, Nonparametric Tests of Alternative Option Pricing Models Using All

Reported Trades and Quotes on the 30 Most Active CBOE Option Classes from August 23,

1976 Through August 31, 1978, Journal of Finance 40, 455-480.

Recommended

1. Bakshi, G., and Z. Chen, 1997a, An Alternative Valuation Model for Contingent Claims,

Journal of Financial Economics 44, 123-165.

2. MacBeth, J., and L. Merville, 1979, An Empirical Examination of the Black-Scholes Call

Option Pricing Model, Journal of Finance 34, 1173-1186.

7.3 Estimating Risk-Neutral Densities

Required

1. At-Sahalia, Y., and A. Lo, 1998, Nonparametric Estimation of State-Price Densities Implicit

in Financial Asset Prices, Journal of Finance 53, 499-548.

2. Dumas, B., J. Fleming, and R. Whaley, 1998, Implied Volatility Functions: Empirical Tests,

Journal of Finance 53, 2059-2106.

3. Jackwerth, J., and M. Rubinstein, 1996, Recovering Probability Distributions from

Contemporary Security Prices, Journal of Finance 51, 1611-1631.

Recommended

1. Ait-Sahalia, Y., and A.W. Lo, 2000, Nonparametric Risk Managament and Implied Risk

Aversion, Journal of Econometrics 94, 9-51.

2. Brandt, M., and T. Wu, 2002, Cross-Sectional Tests of Deterministic Volatility Functions,

Journal of Empirical finance. 9, 525-550

3. Derman, E., and I. Kani, 1994, Riding on the Smile, Risk 7, February 32-39.

4. Dupire, B., 1994, Pricing with a Smile, Risk 7,January 18-20.

5. Rubinstein, M., 1994, Implied Binomial Trees, Journal of Finance 49, 771-818.

7.4 Estimating Real and Risk-Neutral Stock Price Dynamics

Required

1. Chernov, M., and E. Ghysels, 2001, A Study Toward a Unified Approach to the Joint

Estimation of Objective and Risk Neutral Measures for the Purpose of Options Valuation,

Journal of Financial Economics 56, 407-458.

2. Pan, J., 2002, The Jump-Risk Premia Implicit in Options: Evidence from an Integrated

Time-Series Study, Journal of Financial Economics, 63, 3-50

Recommended

1. Chernov, M., R. Gallant, E. Gysels, and G. Tauchen, 1999, A New Class of Stochastic

Volatility Models with Jumps: Theory and Estimation, Working Paper, Columbia University.

2. Jones, C., 2003, The Dynamics of Stochastic Volatility, Journal of Econometrics, 116, 181-224.