Stephen Leroy

• University of California, Santa Barbara

We use a consumption based asset pricing model to show that the predictability of excess returns on risky assets can arise from only two sources: (1) stochastic volatility of fundamental variables, or (2) departures from rational expectations that give rise to predictable investor forecast errors and market inefficiency. While controlling for stoch...

We study the size-power tradeoff of commonly employed tests of return predictability. For short horizon tests, we show analytically that the indirect dividend test is asymptotically more powerful than the direct return test when dividend growth is less volatile than returns, as appears to be true in the data. The asymptotic power advantages of the...

We investigate how deposit insurance affects the structure of the financial system in a general equilibrium setting in which a government insurer guarantees deposits at commercial banks, but not at shadow banks. With deposit-based or risky-asset-based insurance premia, price distortions induced by subsidized deposit insurance benefit shadow banks,...

Statisticians have proposed formal techniques for evaluation of treatments, often in the context of models that do not explicitly specify how treatments are generated. Under such procedures they run the risk of attributing causation in settings where the implementation neutrality condition required for causal interpretation of parameter estimates i...

The most basic question one can ask of a model is ‘What is the effect on variable y 2 of variable y 1 ?’ Causation is ‘implementation neutral’ when all interventions on external variables that lead to a given change in y 1 have the same effect on y 2 , so that the effect of y 1 on y 2 is defined unambiguously. Familiar ideas of causal analysis do n...

This paper employs a standard asset pricing model to derive theoretical volatility measures in a setting that allows for varying degrees of investor information about the dividend process. We show that the volatility of the price-dividend ratio increases monotonically with investor information but the relationship between investor information and e...

Continuous-time stochastic calculus extends the de…nition of the stochas- tic integral to the case where the integrand is not square-integrable using a pointwise limit. Under this extension absence of arbitrage in …nite portfolio strategies is consistent with existence of arbitrage in in…nite portfolio strage- gies. The doubling strategy is the mos...

This paper employs a standard asset pricing framework with power utility to derive model-predicted volatility measures for the price-dividend ratio in a setting that allows for varying degrees of investor information about future dividends. When comparing the model predictions to the data, we …nd evidence of excess volatility in long-run U.S. stock...

Despite the fact that the topic of capital market efficiency plays a central role in introductory instruction in finance, it is difficult to determine exactly what it means. Fama's well-known statement that market efficiency can be tested only jointly with an assumed returns model implies that market efficiency generates restrictions on the data th...

Mortgage lenders impose a default premium on the loans they originate to compensate for the possibility that borrowers won’t make payments. The housing boom of the 2000s was characterized by increasing riskiness of the borrowers approved for mortgages and the structures of the loans themselves. Despite these changes in risk, a pricing model can jus...

House prices have fallen approximately 30% from their peak in 2006, accompanied by a level of defaults and foreclosures without precedent in the post-World War II era. Many homeowners have mortgages with principal amounts higher than the market value of their properties. In general, though, the rational default point is below the "underwater" point...

We study optimal exercise by mortgage borrowers of the option to default. Also, we use an equilibrium valuation model incorporating default to show how mortgage yields and lender recovery rates on defaulted mortgages depend on initial loan-to-value ratios when borrowers default optimally. The analysis treats both the frictionless case and the case...

The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The financial...

Stock prices frequently undergo big changes that do not coincide with commensurate changes in fundamentals (earnings, dividends, interest rates). Shiller and LeRoy and Porter formalized the idea that price volatility is excessive relative to fundamentals by deriving the implications for price volatility of the hypothesis that stock prices equal the...

The present value relation says that, under certainty, the value of a capital good or financial asset equals the summed discounted value of the stream of revenues which that asset generates. Otherwise arbitrage would be possible. Under uncertainty, and if risk neutrality is assumed, the future payoffs are replaced by their conditional expectations....

The manager of a firm that is selling an illiquid asset has discretion as to the sale price: if he chooses a high (low) selling price, early sale is unlikely (likely). If the manager has the option to default on the debt that is collateralized by the illiquid asset, the optimal selling price depends on whether the manager acts in the interests of o...

Bubbles, such as money, cannot be valued in efficient equilibria in overlapping generations models (a borderline case aside). Analysts frequently attribute this result to the fact that if bubbles were valued, the bubble must eventually exceed the endowment of the young. This implies negative consumption by the young, invalidating the equilibrium pa...

A “fire sale” occurs when the owner of a good offers it for sale at a price strictly below the price that some buyers would willingly pay for the good. He does so because the advantage of the quick sale made possible by the lower price outweighs the higher price that other potential buyers would pay, given the likely delay in locating these buyers...

This article reviews the theory of speculative bubbles. Bubbles are a promising candidate as an explanation for the stock price run-up and collapse of the 1990s in the United States. The theory considers both irrational and rational bubbles, with emphasis on the latter. Rational bubbles, defined as the excess of security or portfolio prices over pr...

Recent years have seen a protracted debate on the "fiscal theory of the price level". This doctrine is based on the intertemporal government budget constraint, which says that the real value of the government debt equals the discounted value of future government surpluses. It is observed that the intertemporal government budget constraint consists...

In recent papers Matthew Rabin and Richard H. Thaler have argued that expected utility theory generates implausible predictions about individuals' attitudes toward small vs. large risks. Specifically, these authors argued that expected utility theory, plus the assertion that individuals reject small risks that are actuarially unfavorable, implies t...

By 'the paradox of asset pricing' Peter Bossaerts refers to his contention that, despite its apparent generality and sophistication, the theory of finance has largely been a failure empirically. Bossaerts reviews the major areas of finance: theory, empirical methods, empirical results and experiments. The explanatory variables for average asset ret...

We develop an equilibrium model of illiquid asset valuation based on search and matching. We propose several measures of illiquidity and show how these measures behave. We also show that the equilibrium amount of search may be less than, equal to or greater than the amount of search that is socially optimal. Finally, we show that excess returns on...

Financial economics, and the calculations of time and uncertainty derived from it, are playing an increasingly important role in non-finance areas, such as monetary and environmental economics. Professors Le Roy and Werner here supply a rigorous yet accessible graduate-level introduction to this subfield of microeconomic theory and general equilibr...

Financial economics, and the calculations of time and uncertainty derived from it, are playing an increasingly important role in non-finance areas, such as monetary and environmental economics. In this 2001 book, Professors Le Roy and Werner supply a rigorous yet accessible graduate-level introduction to this subfield of microeconomic theory and ge...

We define rational bubbles to be securities with payoffs occurring in the infinitely distant future and investigate the behavior of bubbles values. We extend our analysis to a setting of uncertainty. In an infinite horizon arbitrage-free model of asset prices, we interpret the money market account as the value of a particular bubble, a similar inte...

Viability of security prices implies linear valuation of payoffs but, if there exist an infinite number of securities or trading dates, does not imply the existence of a risk-neutral probability since countable additivity may fail. An example is given.

The simplest tests of capital market efficiency are tests of the fair game model: conditional expected returns less the interest rate are equal to zero. The fair game model is thought to obtain only when markets are perfectly liquid. We show that this conjecture is false. In a model of the housing market where heterogeneous agents must search for p...

The early interchanges between academics and finance practitioners about capital market efficiency generated more heat than light. Models derived from market efficiency, such as capital asset pricing model (CAPM)-based portfolio management models, made some inroads among practitioners, but for the most part the debate between proponents and opponen...

We define rational bubbles to be securities with payoffs occurring in the infinitely distant future and investigate the behavior of bubble values. We extend our analysis to a setting of uncertainty. In an infinite-horizon arbitrage-free model of asset prices, we interpret the money market account as the value of a particular bubble; a similar inter...

Mortgage originators offer borrowers various combinations of “points”—loan fees—and coupon: high points and low coupon or low points and high coupon. In this article points are interpreted as a device serving to separate borrowers with high prepayment probabilities from those with low prepayment probabilities. Borrowers and lenders are treated symm...

The definition of "fundamental value" and "speculative bubbles" that are standard in macroeconomics and finance are given formal representations as the countably additive part and the purely finitely additive part (a measure and a pure charge, respectively) of the supporting price system when the commodity space is L(infinity). Examples illustrate...

We survey the variance-bounds tests of asset-price volatility, stressing the econometric aspects of these tests. The first variance-bounds tests of the present-value relation reported apparently striking evidence of excess volatility of asset prices. The statistical significance of the results, however, was either marginal or, in the case of model-...

The Arbitrage Pricing Theory relates the expected rates of return on a sequence of primitive securities to their factor exposures, suggesting that factor risk is of critical importance in asset pricing. However, we show that if the sequence of primitive returns is replaced by a sequence of returns on portfolios formed from the primitive securities,...

The present-value relation says that, under certainty, the value of a capital good or financial asset equals the summed discounted value of the stream of revenues which that asset generates. The discount factor will be that determined by the interest rate over the relevant period. The justification for the present-value relation lies in the fact th...

"Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street," observed legendary speculator Jesse Livermore. History tells us that periods of major technological innovation are typically accompanied by speculative bubbles as economic agents overreact to genuine advancements in productivity. Excessive run-ups in asset pri...

It is argued that the received interpretation of Frank Knight's_(1921) classic risk-uncertainty distinction-as concerning whether or not agents have subjective probabilities-constitutes a misreading of Knight. On the contrary, Knight shared the modern view that agents can be assumed always to act as if they have subjective probabilities. The author...

The present-value relation says that, under certainty, the value of a capital good or financial asset equals the summed discounted value of the stream of revenues which that asset generates. The discount factor will be that determined by the interest rate over the relevant period. The justification for the present-value relation lies in the fact th...

Cox, INGERSOLL, AND Ross [1] distinguished various forms of the expectations hypothesis of the term structure of interest rates. They proved that, with one exception, these are consistent with general equilibrium only in the trivial case in which interest rates are nonrandom. The exception is the Local Expectations Hypothesis. Because of this nonex...

The term structure of real interest rates is studied in the context of a consumption-based general-equilibrium model. It is shown that the expectations hypothesis is approximately satisfied for low interest rate volatility. Otherwise the term premia are generally positive.

This paper identifies restrictions on preferences under which various classes of “expectations” theories of asset prices—i.e., uncertainty models of asset prices which coincide with the corresponding certainty theory except that expected future prices replace actual future prices—are valid. Major classes of expectations models surveyed are martinga...

"Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street," observed legendary speculator Jesse Livermore. History tells us that periods of major technological innovation are typically accompanied by speculative bubbles as economic agents overreact to genuine advancements in productivity. Excessive run-ups in asset pri...

The report argues that aid volatility is an important source of volatility for the poorest countries. Following a method already applied by the Agence Française de Développement, the report argues that loans to LICs should incorporate a floating grace period, which the country could draw upon when hit by a shock. The definition of a shock should in...