Asset pricing in a multiperiod securities market with nonnegative wealth constraints

Abstract

According to Black-Scholes option pricing model, options are redundant securities, therefore have no importance for the allocation of wealth in the economy. This dissertation shows that options might be nonredundant when two factors are considered - nonnegative wealth and volatility risk. The first part of the dissertation empirically examines whether options are redundant securities or not in the context of volatility risk. It is documented that volatility risk, proxied by zero-beta at-the-money straddles, captures time variation in the stochastic discount factor. In relation to this, alternative explanations to size and value vs. growth anomalies are given. In the second part of the dissertation, a multiperiod securities market is considered, and a model where agents face nonnegative wealth constraints is developed. Individuals’ associated consumption-investment problem is solved under this constraint, and optimal sharing rules for each agent in the economy are derived, subsequently. The optimal consumption for the representative agent leads to a multifactor conditional C-CAPM, which is the main testable hypothesis of the theory. Overall the theory outlined, and the empirical findings documented have implications for asset pricing, portfolio management, and capital markets theories.