## Financial Asset Pricing TheoryFinancial Asset Pricing Theory offers a comprehensive overview of the classic and the current research in theoretical asset pricing. Asset pricing is developed around the concept of a state-price deflator which relates the price of any asset to its future (risky) dividends and thus incorporates how to adjust for both time and risk in asset valuation. The willingness of any utility-maximizing investor to shift consumption over time defines a state-price deflator which provides a link between optimal consumption and asset prices that leads to the Consumption-based Capital Asset Pricing Model (CCAPM). A simple version of the CCAPM cannot explain various stylized asset pricing facts, but these asset pricing 'puzzles' can be resolved by a number of recent extensions involving habit formation, recursive utility, multiple consumption goods, and long-run consumption risks. Other valuation techniques and modelling approaches (such as factor models, term structure models, risk-neutral valuation, and option pricing models) are explained and related to state-price deflators. The book will serve as a textbook for an advanced course in theoretical financial economics in a PhD or a quantitative Master of Science program. It will also be a useful reference book for researchers and finance professionals. The presentation in the book balances formal mathematical modelling and economic intuition and understanding. Both discrete-time and continuous-time models are covered. The necessary concepts and techniques concerning stochastic processes are carefully explained in a separate chapter so that only limited previous exposure to dynamic finance models is required. |

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### Contents

1 Introduction and Overview | 1 |

2 Uncertainty Information and Stochastic Processes | 24 |

3 Portfolios Arbitrage and Market Completeness | 70 |

4 State Prices | 95 |

5 Preferences | 149 |

6 Individual Optimality | 192 |

7 Market Equilibrium | 249 |

8 Basic ConsumptionBased Asset Pricing | 277 |

11 The Economics of the Term Structure of Interest Rates | 419 |

12 RiskAdjusted Probabilities | 473 |

13 Derivatives | 501 |

A Review of Basic Probability Concepts | 542 |

Results on the Lognormal Distribution | 549 |

Results from Linear Algebra | 552 |

Bibliography | 556 |

579 | |

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### Common terms and phrases

aggregate consumption asset pricing models assume CAPM computed constant consumption growth consumption plan consumption-based continuous-time covariance defined denote derived discrete-time dividend dynamics economy equation equilibrium equity premium equity premium puzzle example excess return Exercise expected return expected utility future geometric Brownian motion given gross rate implies interest rate investment investors Itô's Lemma Lemma lognormally market price matrix mean-variance efficient nominal normally distributed optimal consumption option payment period portfolio price of risk pricing factor probability measure random variable rate of return relative risk aversion representative individual risk premium risk-free asset risk-free rate risk-neutral probability risk-neutral probability measure risky assets Section Sharpe ratio short-term sigma-algebra standard Brownian motion state-price deflator state-price vector stochastic process swap Theorem time-additive expected utility trading strategy utility function variance volatility zero zero-coupon bond