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By Jason Wei


Classifying asset-pricing models is a treacherous venture, because many seemingly distinct modelling frameworks are intricately related. However, for this discussion, I will put all financial asset-pricing models into two broad categories: equilibrium models and arbitrage-based models. Carmichael’s paper focuses on the first group of models. Lucas’s seminal 1978 article laid the foundation of consumption-based or dynamicequilibrium models, and his 1982 article extended the model to a twocountry setting. Other major contributors in this area include: Merton (1973); Breeden (1979); and Cox, Ingersoll, and Ross (1985). A distinctive feature of consumption-based models is that the agent’s risk-preference or utility functions must be specified. Once a utility function is in place, maximizing the intertemporal expected utility leads to the usual first-order conditions, the so-called Euler equations, which ultimately govern the prices of financial assets. Insofar as Euler equations are the source of asset price dynamics, specifying the agent’s utility function is crucial. In contrast, arbitrage-based models are free of investors ’ risk preferences. In the remainder of this discussion, I will mainly review arbitragebased models to complement Carmichael’s paper. The review will discuss the framework of arbitrage pricing as it is applied to derivative financial assets. In the spirit of the conference theme, I will try to relate the discussions to the market’s information structures, and compare the two groups of models whenever possible and appropriate. Most of the material

Year: 2011
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