Asset pricing.

• Author: Campbell, John Y.

Asset pricing - the study of markets for financial assets including stocks, bonds, foreign currencies, and derivatives - is a field in which there is an intense and fruitful interaction between empirical and theoretical research. The work of economists associated with the NBER Asset Pricing Program illustrates this interaction particularly well. NBER economists have been studying many different phenomena, including the high rewards that investors have received for holding stocks in general and "value stocks" in particular, the apparent predictability of stock and bond returns at long horizons, and unusual patterns in option prices. In each area, empirical puzzles have stimulated new thinking about investor behavior and the functioning of capital markets.

Financial markets are, of course, changing rapidly. NBER economists have been following these developments, and in some cases have tried to anticipate or influence them. There has been much research on international capital markets and the opportunities they present for risksharing across countries; other work has discussed new types of securities, including inflation-indexed bonds, which were issued for the first time by the U.S. Treasury in January 1997.

Cross-Sectional Patterns in Stock Returns

Historically, investors have received handsome rewards for bearing the risk of investments in equity markets. Economists have found it difficult to rationalize the size of this "equity premium".(1)

Recent research on individual U.S. stocks has uncovered facts that make this puzzle even more challenging. First, the average excess returns on value stocks - stocks whose prices are low relative to their book values, earnings, or dividends - are even higher than the average excess returns on stocks in general. Second, there seems to be a "momentum effect": stocks that have outperformed the market during the last few months tend to outperform the market during subsequent months.

There is an active debate about how to interpret these phenomena. Eugene Fama and Kenneth French have proposed that value stocks deliver higher average returns because they are riskier.(2) Other NBER economists have challenged this view. Craig MacKinlay argues that it requires an implausibly high reward for bearing risk,(3) while Rafael La Porta, Josef Lakonishok, Andrei Shleifer, and Robert Vishny suggest that investors underprice value stocks because they are too pessimistic about the earnings of these companies. They show that as much as one third of the excess return on value stocks occurs in the few days around earnings announcements, suggesting that investors are on average favorably surprised by the earnings of value stocks.(4) Louis Chan, Narasimhan Jegadeesh, and Lakonishok document a similar tendency for the excess return on momentum stocks to occur near earnings announcements, suggesting that for these stocks also investors tend to have incorrect earnings expectations.(5)

Nicholas Barberis, Shleifer, and Vishny have built an explicit model of investors' irrational expectations that can generate excess returns on both momentum stocks and value stocks. In their model, earnings growth cannot be forecast, so the best forecast of future earnings is just the current level of earnings. Investors normally expect earnings to revert to some long-run average level, which leads them to underprice stocks that have experienced recent earnings growth (momentum stocks). A series of positive or negative earnings surprises, however, can lead investors to expect continued positive or negative earnings growth; this leads them to underprice stocks that have performed extremely badly (value stocks).(6)

Time-Variation in the Reward for Risk

Financial ratios of stock prices to book values, earnings, or dividends also are used in...