Includes bibliogr. references (p. 415-431) and index.

Part I Single-Period Portfolio Choice and Asset Pricing 1 -- 1 Expected Utility and Risk Aversion 3 -- 1.1 Preferences When Returns Are Uncertain 4 -- 1.2 Risk Aversion and Risk Premia 11 -- 1.3 Risk Aversion and Portfolio Choice 19 -- 2 Mean-Variance Analysis 27 -- 2.1 Assumptions on Preferences and Asset Returns 28 -- 2.2 Investor Indifference Relations 31 -- 2.3 The Efficient Frontier 34 -- 2.3.2 Mathematics of the Efficient Frontier 37 -- 2.3.3 Portfolio Separation 40 -- 2.4 The Efficient Frontier with a Riskless Asset 44 -- 2.4.1 An Example with Negative Exponential Utility 48 -- 2.5 An Application to Cross-Hedging 50 -- 3 CAPM, Arbitrage, and Linear Factor Models 57 -- 3.1 The Capital Asset Pricing Model 58 -- 3.1.1 Characteristics of the Tangency Portfolio 59 -- 3.1.2 Market Equilibrium 60 -- 3.2 Arbitrage 66 -- 3.2.1 Examples of Arbitrage Pricing 67 -- 3.3 Linear Factor Models 70 -- 4 Consumption-Savings Decisions and State Pricing 79 -- 4.1 Consumption and Portfolio Choices 80 -- 4.2 An Asset Pricing Interpretation 84 -- 4.2.1 Real versus Nominal Returns 85 -- 4.2.2 Risk Premia and the Marginal Utility of Consumption 86 -- 4.2.3 The Relationship to CAPM 86 -- 4.2.4 Bounds on Risk Premia 88 -- 4.3 Market Completeness, Arbitrage, and State Pricing 91 -- 4.3.1 Complete Markets Assumptions 92 -- 4.3.2 Arbitrage and State Prices 93 -- 4.3.3 Risk-Neutral Probabilities 95 -- 4.3.4 State Pricing Extensions 97 -- Part II Multiperiod Consumption, Portfolio Choice, and Asset Pricing 101 -- 5 A Multiperiod Discrete-Time Model of Consumption and Portfolio Choice 103 -- 5.1 Assumptions and Notation of the Model 105 -- 5.1.1 Preferences 105 -- 5.1.2 The Dynamics of Wealth 106 -- 5.2 Solving the Multiperiod Model 107 -- 5.2.1 The Final Period Solution 108 -- 5.2.2 Deriving the Bellman Equation 110 -- 5.2.3 The General Solution 112 -- 5.3 Example Using Log Utility 113 -- 6 Multiperiod Market Equilibrium 121 -- 6.1 Asset Pricing in the Multiperiod Model 122 -- 6.1.1 The Multiperiod Pricing Kernel 122 -- 6.2 The Lucas Model of Asset Pricing 124 -- 6.2.1 Including Dividends in Asset Returns 125 -- 6.2.2 Equating Dividends to Consumption 127 -- 6.2.3 Asset Pricing Examples 127 -- 6.2.4 A Lucas Model with Labor Income 129 -- 6.3 Rational Asset Price Bubbles 131 -- 6.3.1 Examples of Bubble Solutions 133 -- 6.3.2 The Likelihood of Rational Bubbles 133 -- Part III Contingent Claims Pricing 139 -- 7 Basics of Derivative Pricing 141 -- 7.1 Forward and Option Contracts 142 -- 7.1.1 Forward Contracts on Assets Paying Dividends 142 -- 7.1.2 Basic Characteristics of Option Prices 145 -- 7.2 Binomial Option Pricing 149 -- 7.2.1 Valuing a One-Period Option 150 -- 7.2.2 Valuing a Multiperiod Option 153 -- 7.3 Binomial Model Applications 156 -- 7.3.1 Calibrating the Model 157 -- 7.3.2 Valuing an American Option 158 -- 7.3.3 Options on Dividend-Paying Assets 162 -- 8 Essentials of Diffusion Processes and Ito's Lemma 165 -- 8.1 Pure Brownian Motion 166 -- 8.1.1 The Continuous-Time Limit 167 -- 8.2 Diffusion Processes 169 -- 8.2.1 Definition of an Ito Integral 170 -- 8.3 Functions of Continuous-Time Processes and Ito's Lemma 172 -- 8.3.1 Geometric Brownian Motion 174 -- 8.3.2 Kolmogorov Equation 175 -- 8.3.3 Multivariate Diffusions and Ito's Lemma 177 -- 9 Dynamic Hedging and PDE Valuation 181 -- 9.1 Black-Scholes Option Pricing 182 -- 9.1.1 Portfolio Dynamics in Continuous Time 182 -- 9.1.2 Black-Scholes Model Assumptions 185 -- 9.1.3 The Hedge Portfolio 186 -- 9.1.4 No-Arbitrage Implies a PDE 187 -- 9.1 An Equilibrium Term Structure Model 189 -- 9.2.1 A Bond Risk Premium 193 -- 9.2.2 Characteristics of Bond Prices 194 -- 9.3 Option Pricing with Random Interest Rates 195 -- 10 Arbitrage, Martingales, and Pricing Kernels 203 -- 10.1 Arbitrage and Martingales 204 -- 10.1.1 A Change in Probability: Girsanov's Theorem 206 -- 10.1.2 Money Market Deflator 208 -- 10.1.3 Feynman-Kac Solution 209 -- 10.2 Arbitrage and Pricing Kernels 210 -- 10.2.1 Linking the Valuation Methods 212 -- 10.2.2 The Multivariate Case 213 -- 10.3 Alternative Price Deflators 213 -- 10.4 Applications 215 -- 10.4.1 Continuous Dividends 216 -- 10.4.2 The Term Structure Revisited 219 -- 11 Mixing Diffusion and Jump Processes 225 -- 11.1 Modeling Jumps in Continuous Time 226 -- 11.2 Ito's Lemma for Jump-Diffusion Processes 227 -- 11.3 Valuing Contingent Claims 228 -- 11.3.1 An Imperfect Hedge 229 -- 11.3.2 Diversifiable Jump Risk 231 -- 11.3.3 Lognormal Jump Proportions 232 -- 11.3.4 Nondiversifiable Jump Risk 233 -- 11.3.5 Black-Scholes versus Jump-Diffusion Model 234 -- Part IV Asset Pricing in Continuous Time 239 -- 12 Continuous-Time Consumption and Portfolio Choice 241 -- 12.1 Model Assumptions 242 -- 12.2 Continuous-Time Dynamic Programming 244 -- 12.3 Solving the Continuous-Time Problem 246 -- 12.3.1 Constant Investment Opportunities 247 -- 12.3.2 Changing Investment Opportunities 252 -- 12.4 The Martingale Approach to Consumption and Portfolio Choice 258 -- 12.4.1 Market Completeness Assumptions 259 -- 12.4.2 The Optimal Consumption Plan 260 -- 12.4.3 The Portfolio Allocation 263 -- 13 Equilibrium Asset Returns 275 -- 13.1 An Intertemporal Capital Asset Pricing Model 276 -- 13.1.1 Constant Investment Opportunities 276 -- 13.1.2 Stochastic Investment Opportunities 278 -- 13.1.3 An Extension to State-Dependent Utility 280 -- 13.2 Breeden's Consumption CAPM 280 -- 13.3 A Cox, Ingersoll, and Ross Production Economy 283 -- 13.3.1 An Example Using Log Utility 289 -- 14 Time-Inseparable Utility 295 -- 14.1 Constantinides' Internal Habit Model 296 -- 14.1.2 Consumption and Portfolio Choices 300 -- 14.2 Campbell and Cochrane's External Habit Model 304 -- 14.2.2 Equilibrium Asset Prices 305 -- 14.3 Recursive Utility 308 -- 14.3.1 A Model by Obstfeld 309 -- 14.3.2 Discussion of the Model 313 -- Part V Additional Topics in Asset Pricing 319 -- 15 Behavioral Finance and Asset Pricing 321 -- 15.1 The Effects of Psychological Biases on Asset Prices 323 -- 15.1.2 Solving the Model 326 -- 15.1.3 Model Results 329 -- 15.2 The Impact of Irrational Traders on Asset Prices 329 -- 15.2.2 Solution Technique 331 -- 15.2.3 Analysis of the Results 335 -- 16 Asset Pricing with Differential Information 343 -- 16.1 Equilibrium with Private Information 344 -- 16.1.1 Grossman Model Assumptions 344 -- 16.1.2 Individuals'Asset Demands 345 -- 16.1.3 A Competitive Equilibrium 346 -- 16.1.4 A Rational Expectations Equilibrium 347 -- 16.1.5 A Noisy Rational Expectations Equilibrium 349 -- 16.2 Asymmetric Information, Trading, and Markets 352 -- 16.2.1 Kyle Model Assumptions 352 -- 16.2.2 Trading and Pricing Strategies 353 -- 16.2.3 Analysis of the Results 356 -- 17 Models of the Term Structure of Interest Rates 361 -- 17.1 Equilibrium Term Structure Models 361 -- 17.1.1 Affine Models 364 -- 17.1.2 Quadratic Gaussian Models 368 -- 17.1.3 Other Equilibrium Models 371 -- 17.2 Valuation Models for Interest Rate Derivatives 371 -- 17.2.1 Heath-Jarrow-Morton Models 372 -- 17.2.2 Market Models 382 -- 17.2.3 Random Field Models 389 -- 18 Models of Default Risk 397 -- 18.1 The Structural Approach 398 -- 18.2 The Reduced-Form Approach 401 -- 18.2.1 A Zero-Recovery Bond 402 -- 18.2.2 Specifying Recovery Values 404.