University of Texas at Dallas

School of Management

Doctoral Seminar in Asset Pricing Theory (FIN 7330)

Course Objectives:

This course provides an in-depth discussion on equilibrium and no-arbitrage asset pricing theory. We
will derive classic results in asset pricing theory including the Capital Asset Pricing Model, Arbitrage
Pricing Theory, Merton’s continuous time model, the Cox-Ingersoll-Ross term structure model, the
Black-Scholes option pricing model, and the rational expectations equilibrium models. We emphasize
the fundamental concepts in order to prepare you to do research in financial economics. We will
focus on models with symmetric information. Asset pricing under asymmetric information will be
introduced if time permits.

Texts:

The main textbook for this class is Asset Pricing, revised edition by John H. Cochrane, Princeton
University Press, 2005. The following books are also very good references:
1. Ingersoll, Jonathan, Theory of Financial Decisionmaking, Rowman and Littlefield, 1987.
2. Huang and Litzenberger, Foundations for Financial Economics, North-Holland (Elsevier
Science Publishing, New York) 1988.
3. Duffie, Darrell, Dynamic Asset Pricing Theory, Princeton University Press, 1995.
4. Mas-Colell, Andreu, Michael D. Whinston, and Jerry R. Green, Microeconomic Theory,
Oxford University Press, 1995

Course Requirements:

We will meet on Thursday from 9:00-11:45AM for lectures. In addition, I will hold office hours on
the same day 2:00-5:00PM or by appointment. My office is located in room SM3.806 on the third
floor of the School of Management building. You can reach by phone at 883-4777 or email at
harold.zhang@utdallas.edu. If you are interested in my research, check my webpage at
http://www.utdallas.edu/~hza054000.

Problem sets will be distributed approximately once a week. It is fine to discuss the assignments
as a group. However, each individual should write his/her solutions independently. There will be
a three hour in class, closed book, closed notes final exam. Instead of a midterm exam, I will ask
each of you to write a “research/review” paper on an assigned paper. In Week 13, you will give a
20-minute presentation in class as if it were your own research results. This is a good way to get
you started on doing research. Homework assignments account for 30% of the course grade; the
presentation accounts for 20%, and the final exam accounts for 50%.
Topics:

The following is a list of topics that will be covered in the course along with the associated
reading assignments.

Date Topic Readings

January 12 Introduction Cochrane, CH 1.

January 19 Equilibrium and Arbitrage Cochrane, CH 3.

Preferences and utility theory

Risk aversion and intertemporal substitution
State contingent and Arrow-Debreu securities
Arbitrage opportunity
Complete markets
Risk-neutral pricing

January 26 State Preference Models Cochrane, CH 4.

Relationship among no arbitrage, state prices, and equilibrium

Determining state prices
Asset allocation and consumption smooth
State prices in a two-period world
State prices in a multi-period world
Individual optimality versus Pareto optimality
A state pricing model with log utility

February 2 The Stochastic Discount Factor Model Cochrane, CH 1, 2, 21

An investor’s problem and first order condition

Relation to state preference theory
Introducing the concept of stochastic discount factor
The equilibrium solution and return distribution
The equity premium implications

Additional readings:
Lucas, Robert (1978), “Asset prices in an exchange economy,” Econometrica 46:1429-1445
Kocherlakota, Narayana R. (1996), “The equity premium: It’s still a puzzle,” Journal of
Economic Literature, Vol. 34, No. 1, pp. 42-71.
February 9 The Mean-variance Frontier and Cochrane CH 5, 9, 20
the Capital Asset Pricing Model (CAPM)

Mathematics of the portfolio frontier

Properties of frontier portfolios
The Hansen-Jagannathan bound
The CAPM

Additional readings:
Hansen, Lars Peter, and Ravi Jagannathan (1991) “Implications of Security Market Data for
Models of Dynamic Economies,” Journal of Political Economy 99:225-262.
Sharpe, William (1964), “Capital asset prices: a theory of market equilibrium under
conditions of risk,” Journal of Finance 19:425-42.

February 16 The Arbitrage Pricing Theory (APT) Cochrane, CH 9.

Pricing with zero residual risk

Asymptotic arbitrage
Bounding the error in the APT
CAPM versus APT

Additional readings:
Ross, Stephen A. (1976), “The arbitrage theory of capital asset pricing,” Journal of
Economic Theory 13:341-360.
Huberman, Gur (1982), “A simple approach to arbitrage pricing theory,” Journal of
Economic Theory 28, 183-191.

February 23 Log-linearization Approximation and Cochrane, Appendix

Continuous Time Mathematics

Additional reading:
Campbell, John Y. (1991), “A Variance Decomposition for Stock Returns,” The
Economic Journal, Vol. 101, No. 405, pp. 157-79.

March 2 The Intertemporal Capital Asset Pricing Model Cochrane, CH 9

The Merton model

The continuous time CAPM
A multi-beta pricing model
The Breeden’s consumption CAPM

Additional readings:
Merton, Robert C. (1973), “An intertemporal capital asset pricing model,” Econometrica
41:867-887.
Breeden, Douglas (1979), “An intertemporal asset pricing model with Stochastic
consumption and investment opportunities,” Journal of Financial Economics 7:265-
March 16 The Black--Scholes Option Pricing Model Cochrane, CH 17, 18

Black-Scholes derivation
An alternative approach
Equivalent Martingale measure
Solving Black-Scholes using Martingale approach
Additional readings:
Black, Fischer and Myron Scholes (1973), “The pricing of options and corporate liabilities,”
Journal of Political Economy 81:637-654.
Merton, Robert (1973), “The theory of rational option pricing,” Bell Journal of Economics
and Management Science 4:141-183.
Rubinstein, Mark (1994), “Implied binomial trees,” Journal of Finance, Vol. 49, No. 3,
pp. 771-818.

March 23 The Term Structure Model Cochrane, CH 19

An equilibrium model of the term structure

The CIR term structure model
Affine term structure models

Additional readings:
Cox, John, Jonathan Ingersoll, and Stephen Ross (1985), “An intertemporal general
equilibrium model of asset prices,” Econometrica 53:363-384.

March 30 Class Presentations

April 6 Rational Expectations and Informational Role of Prices

Readings:
Jordan, J. and Radner, R. (1982), “Rational Expectations in microeconomic models: An
overview,” Journal of Economic Theory 26:201-223.
Milgrom, P. and Stokey, N. (1982), “Information, trade and common knowledge,” Journal
of Economic Theory 26:17-27.
Harris, Milton and Artur Raviv (1993), “Differences of opinion make a horse race,” Review
of Financial Studies,” V6, No.3, pp473-506.

April 13 Noisy Rational Expectations and Information Acquisitions

Readings:
Admati, A. R. and Pfleiderer, P. (1990), “Direct and indirect sales of information,”
Econometrica, 58: 901-928.
 Grossman, S. and Stiglitz, J. (1980), “On the impossibility of informationally efficient
markets,” American Economic Review 70:393-408.

April 20 Final exam (3hr in class)

 List of Papers for Class Presentation

Bansal, Ravi, and Amir Yaron (2004), “Risks for the Long Run: A Potential Resolution of Asset
Pricing Puzzles,” Journal of Finance 59: 1481-1509.

Bekaert, Geert, and Jun Liu (2004), “Conditioning Information and Variance Bounds on Pricing
Kernels,” Review of Financial Studies 17: 339-378.

Dai, Qiang, and Kenneth Singleton (2003), “Term Structure Dynamics in Theory and Reality,”
Review of Financial Studies 16: 631-678.

Eisfeldt, Andrea L. (2004), “Endogenous Liquidity in Asset Markets,” Journal of Finance 59: 1-30.

Elton, Edwin J., and Martin J. Gruber (2004), “Optimum Centralized Portfolio Construction with
Decentralized Portfolio Management,” Journal of Financial and Quantitative Analysis 39: 481-494.

Ferguson, Michael F. and Richard L. Shockley (2003), “Equilibrium `Anomalies’,” Journal of

Finance 58: 2549-2580.

Ferson, Wayne E., and Adrew F. Siegel (2003), “Stochastic Discount Factor Bounds with
Conditioning Information,” Review of Financial Studies 16: 567-595.

Guo, Hui (2004), “Limited Stock Market Participation and Asset Prices in a Dynamic Economy,”
Journal of Financial and Quantitative Analysis 39: 495-516.

Hong, Harrison, and Jeremy C. Stein (2003), “Differences of Opinion, Short-Sales Constraints, and
Market Crashes,” Review of Financial Studies 16: 487-525.

Kandel, Shmuel, and Robert F. Stambaugh (1995), “Portfolio inefficiency and the cross-section
of expected returns,” Journal of Finance, Vol. 50, No. 1, pp. 157-184.

Liu, Hong (2004), “Optimal consumption and Investment with Transaction Costs and Multiple Risky
Assets,” Journal of Finance 59: 289-338.

Liu, Jun, and Francis A. Longstaff (2004), “Losing Money on Arbitrage: Optimal Dynamic Portfolio
Choice in Markets with Arbitrage Opportunities,” Review of Financial Studies 17: 611-641.

Ross, Stephen A. (2004), “Compensation, Incentives, and the Duality of Risk Aversion and
Riskiness,” Journal of Finance 59: 207-225.

Vanden, Joel M. (2004), “Options Trading and the CAPM,” Review of Financial Studies 17: 207-
238.

Vassalou, Maria, and Yuhang Xing (2004), “Default Risk in Equity Return,” Journal of Finance 59:
831-868.
Avramov, Doron (2004), “Stock Return Predictability and Asset Pricing Model,” Review of Financial
Studies 17: 699-738.

Demarzo, Peter M., Ron Kaniel, and Ilan Kremper (2004), “Diversification as a Public Good:
Community Effects in Portfolio Choice,” Journal of Finance 59: 1677-1715.
 University of Texas at Dallas
School of Management
Asset Pricing Theory (FIN 7330)
Spring 2005

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