Asset Pricing Coursework Part 2 This coursework is based on Lucass Consumption CAPM: Lucas, R.E.

(1978) Asset Prices in an Exchange Economy, Econometrica 46(6), pages 14291445.

Consider a world with a single representative agent in which a random and exogenous amount of perishable output dt falls from a fruit tree each period. (There is no other output). Output follows the stochastic process ln dt = ln dt1 + t , Et1 t = 0. where the identically and independently distributed shock t is distributed N (0, 2 ). There is no way to grow more fruit trees. The agents lifetime utility function is Et
s=t

(1)

e(st) u(cs )

where > 0 is the rate of time preference. Assume there is a competitive stock market in which people can trade shares in the fruit tree, whose price on date t is denoted by pt . (If you buy a share on date t, you get your rst dividend only on date t + 1, so pt is an ex dividend price.) 1. Show that a representative individual will choose contingent consumption plans such that on each date pt u (ct ) = e Et ((pt+1 + dt+1 )u (ct+1 )) (use the individual nance constraint that ct +pt zt+1 (dt +pt )zt ), where zt is the share of the fruit tree the individual holds at the end of period t). 1

2. Show that in equilibrium, the fundamental or bubble-free price of the tree is: p t = Et
s=t+1

e(st)

u (ds ) ds . u (dt )

3. Interpret this formula in terms of expected payos and a risk-premium. What is the sign of the risk-premium on the tree, and why? 4. Let agents have the utility function u(c) = c1 1 1

where > 0. Show that equation (1) implies Et (d1 ) = d1 e( t s

2 (1 2 )(st)/2)

(To do this you will need to look up properties of the lognormal probability distribution in your textbook). 5. Deduce from question 4 that if > 2 (1 )2 /2 then p = dt where t = 1 e2 (1)2 /2 1

6. Now return to a strictly concave utility function u(c). Let bt be the random variable Ad /u (dt ), where = 2/ 2 and A is an arbitrary t constant. Show that p + bt will satisfy the individuals Euler equation t (i.e. pt u (ct ) = e Et ((pt+1 + dt+1 )u (ct+1 ))) in equilibrium, so that bt is an asset-price bubble. Show that pt = p + bt violates the (equilibrium) t transversality condition lim e(T t) Et (u (dT +t )pT +t ) = 0. (2)

7. Together with the equilibrium Euler equation pt u (dt ) = e Et [(pt+1 + dt+1 ) u (dt+1 )] (3)

condition (2) is sucient for a stochastic price path {pt } to be an equilibrium. In this part, we show the necessity of (2). Iterate (3) forward to derive pt u (dt ) = Et [
s=t+1

] e(st) u (ds )ys + lim e(T t) Et (u (dT +t )pT +t ) .

T

(This is the same step leading to the solution p in question 2). t Argue that if the limit above is strictly negative, everyone would want to buy more of the tree and never sell it. Then argue symmetrically that if the limit is strictly positive, we cannot be looking at an equilibrium either. Why? Individuals could then raise expected lifetime utility through the following strategy: sell a tiny amount of the fruit tree today and consume the proceeds of that sale now, never repurchasing the portion of the fruit tree sold (that is, reduce the asset demand zt , which equals 1 in the hypothesised equilibrium, permanently). Why does the Euler equation (3) not suce to rule out the possibility that such a strategy raises expected lifetime utility? Assessment Criteria This exercise comprises one part of your coursework. It is worth 20% of the overall grade. You will work within the group you have been assigned for the rst part of the coursework. Each member of the group will be awarded equal marks. I will choose groups and/or individuals randomly to demonstrate their solution of various parts of this coursework to the class. Hence, all students must understand their groups solution approach adequately to ensure they do not let themselves or their group down. A student who demonstrates an extremely poor eort, or who fails to show up for this 3

class without an adequate excuse, will be penalised in terms of their individual coursework grade. This will not necessarily impact on the other members of the group. This will take place during the nal lecture on December 8th 2011. Submission The deadline for this coursework is 5PM on Thursday 1 December, 2011. Late submissions will NOT be accepted and will receive a nil mark. Your Microsoft Word or PDF le with all of your workings must be submitted through the course submission box in Moodle. Remember to include the full names of all group members, along with your group name (i.e. Group A etc) with your document.