Abstract
This chapter extends the model to uncertainty in order to explain the crucial difference between equity and debt. When households hold equity, they face future returns that tend to be high in good times and low in bad times. Thus, they demand a return on equity that is higher than the return on debt as a compensation for the pro-cyclical returns. When firms are maximizing their profits, they will use debt only if the future profits by the use of debt are larger than the costs in terms of interest payments on debt on average.
This is a preview of subscription content, log in via an institution.
Buying options
Tax calculation will be finalised at checkout
Purchases are for personal use only
Learn about institutional subscriptionsNotes
- 1.
The return on equity is on average higher than the risk-free interest rate.
- 2.
\(\mathbb {E} _t\left [\ldots \right ]\) denotes the expectation conditional on z t.
- 3.
In case of a Cobb–Douglas production function, multiplying the production function with the state of the world can be interpreted as labor-augmenting technological progress under uncertainty: zF(L, K) = (z 1∕a L)a K 1−a = F(z 1∕a L, K).
- 4.
Note that \(\mathbb E_t\left [\text{SDF}_{t+1}\right ]=\frac {1}{1+r_{t+1}}\). This follows from the definition of the stochastic discount factor (6.9) and from the fact that \(\Delta _{t+1}^*\) is a probability measure.
- 5.
We see immediately that \(U(\mathbb E[C])=\mathbb E[U(C)]\).
References
Banz, R. W. (1981). The relationship between return and market value of common stocks. Journal of Financial Economics, 9 (1), 2–18.
Basu, S. (1977). Investment performance of common stocks in relation to their price-earnings ratios: A test of the efficient market hypothesis. Journal of Finance, 32 (3), 663–682.
Breeden, D. T. (1979). An intertemporal asset pricing model with stochastic consumption and investment opportunities. Journal of Financial Economics, 7 (3), 265–296.
Carhart, M. M. (1997). On persistence in mutual fund performance. Journal of Finance, 52 (1), 57–82.
Cochrane, J. H. (1991). Production-based asset pricing and the link between stock returns and economic fluctuations. Journal of Finance, 46 (1), 209–237.
Dittmar, R. F. (2002). Nonlinear pricing kernels, kurtosis preference, and evidence from the cross section of equity returns. Journal of Finance, 57 (1), 369–403.
Drèze, J. H. (Ed.). (1974). Allocation under uncertainty: Equilibrium and optimality. London: Palgrave Macmillan.
Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance, 47 (2), 427–465.
Fama, E. F., & French, K. R. (1999). Value versus growth: The international evidence. Journal of Finance, 53 (6), 1975–1999.
Hansen, L. P., & Jagannathan, R. (1991). Implications of security market data for models of dynamic economies. Journal of Political Economy, 99 (2), 225–262.
Harvey, C. R., & Siddique, A. (2000). Conditional skewness in asset pricing tests. Journal of Finance, 55 (3), 1263–1295.
Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. The Review of Economics and Statistics, 47 (1), 13–37.
Lucas, R. E. (1978). Asset prices in an exchange economy. Econometrica, 46 (6), 1429–1445.
Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7 (1), 77–91.
Mehra, R., & Prescott, E. C. (1985). The equity premium: A puzzle. Journal of Monetary Economics, 15 (2), 145–161.
Modigliani, F., & Miller, H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48 (3), 261–297.
Modigliani, F., & Miller, H. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34 (4), 411–433 (1961)
Mossin, J. (1966). Equilibrium in a capital asset market. Econometrica: Journal of the Econometric Society, 34 (4), 768–783.
Rubinstein, M. (1976). The valuation of uncertain income streams and the pricing of options. The Bell Journal of Economics, 7 (2), 407–425.
Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19 (3), 425–442.
Sharpe, W. F. (1966). Mutual fund performance. Journal of Business, 39 (1), 119–138.
Tobin, J. (1969). A general equilibrium approach to monetary theory. Journal of Money, Credit and Banking, 1 (1), 15–29.
Author information
Authors and Affiliations
Rights and permissions
Copyright information
© 2019 Springer Nature Switzerland AG
About this chapter
Cite this chapter
Hens, T., Elmiger, S. (2019). Extension of the Model to Uncertainty. In: Economic Foundations for Finance. Springer Texts in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-030-05427-4_6
Download citation
DOI: https://doi.org/10.1007/978-3-030-05427-4_6
Published:
Publisher Name: Springer, Cham
Print ISBN: 978-3-030-05425-0
Online ISBN: 978-3-030-05427-4
eBook Packages: Economics and FinanceEconomics and Finance (R0)