This paper is concerned with the asset pricing implications of the substantial proportion of equity portfolios that are managed on an agency basis. Portfolio managers who act as agents are assumed to be concerned with the mean and variance of their return measured relative to a benchmark portfolio. Depending on how the benchmark portfolios are chosen, this will affect the equilibrium structure of expected returns. The empirical analysis, which assumes that the benchmark can be identified with the S&P500 portfolio, finds evidence of the pricing effects predicted by the agency model.

Between January 1980 and August 2000 American stock prices as measured by the S&P500 index rose by 1239%; over the same period the dividends on the shares underlying the index rose by only 188%, while the earnings rose by 254%. Between August 2000 and February 2003 the price index fell by 44% and, at the time of writing, some three and a half years later, the index is still some 25% below its August 2000 level, despite the fact that long term interest rates have fallen by around 100 basis points, and the fall is much greater if measured in terms of foreign currency such as the Euro. As Figure 1 shows, American stock price behavior at the turn of the millennium had all the characteristics of a classic bubble;2 prices climbed much faster than dividends or earnings, particularly starting from the beginning of 1995. What caused this?

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The relation between the volatilities of pricing kernels associated with di�erent currencies and the volatility of the exchange rate between the currencies is derived under the assumption of integrated capital markets, and the volatilities of the pricing kernels are related to the foreign exchange risk premium. Time series of pricing kernel volatilities are estimated from panel data on bond yields for five major currencies using a parsimonious term structure model that allows for time varying pricing kernel volatilities. The resulting estimates are used to test hypotheses about the relation between the volatilities of the pricing kernels in di�erent currencies and the volatility of the exchange rate. As predicted, time variation in foreign exchange risk premia is found to be related to time variation in both the volatility of the pricing kernels and the volatility of exchange rates: the estimated pricing kernel volatilities can account for the forward premium puzzle in an ‘average’ sense across exchange rates.

The apparent inconsistency between the Tobin Separation Theorem and the advice of popular investment advisors pointed out by Canner et al (1997) is shown to be explicable in terms of the hedging demands of optimising long-term investors in an environment in which the investment opportunity set is subject to stochastic shocks.

This paper presents an empirical test of the Brennan Kraus (1987) hypothesis of convertible bond financing, according to which firms signal their volatility by their choice of terms of the convertible issue. With additional assumptions about the nature of investors’ prior beliefs about firm types the model predicts that the announcement period return will be positive related to the face value of the convertible, and negatively related to the fraction of the firm accruing to the convertible holders on conversion. The empirical evidence for a sample of public issues strongly supports these predictions, while that for a sample of private placements does not, which is consistent with problems of information asymmetry being important for the former but not for the latter.

We analyze the risk characteristics and the valuation of assets in an economy in which the investment opportunity set is described by the real interest rate and the maximum Sharpe ratio. It is shown that, holding constant the beta of the underlying cash flow, the beta of a security is a function of the maturity of the cash flow. For parameter values estimated from U.S. data, the security beta is always increasing with the maturity of the underlying cash flow, while discount rates for risky cash flows can be increasing, decreasing or nonmonotone functions of the maturity of the cash flow. The variation in discount rates and present value factors that is due to variation in the real interest rate and the Sharpe ratio is shown to be large for long maturity cash flows, and the component of the volatility that is due to variation in the Sharpe ratio is more important than that due to variation in the real interest rate.

We develop a simple framework for analyzing a finitehorizon investor’s asset allocation problem under inflation when only nominal assets are available. The investor’s optimal investment strategy and indirect utility are given in simple closed form. Hedge demands depend on the investor’s horizon and risk aversion and on the maturities of the bonds included in the portfolio. When short positions are precluded, the optimal strategy consists of investments in cash, equity, and a single nominal bond with optimally chosen maturity. Both the optimal stockbond mix and the optimal bond maturity depend on the investor’s horizon and risk aversion.

The optimal portfolio strategy is developed for an investor who has detected an asset pricing anomaly but is not certain that the anomaly is genuine rather than merely apparent. He analysis takes account of the fact that the parameters of both the underlying asset pricing model and the anomalous returns are estimated rather than known. The value that an investor would place on the ability to invest to exploit the apparent anomaly is also derived an illustrative calculations are presented for the Fama and French SMB and HML portfolios, whose returns are anomalous relative to the CAPM.

We estimate the parameters of pricing kernels that depend on both aggregate wealth and state variables that describe the investment opportunity set, using FTSE 100 and S&P 500 index option returns as the returns to be priced. The coefficients of the state variables are highly significant and remarkably consistent across specifications of the pricing kernal, and across the two markets. The results provided further strong evidence, which is consistent with Merton's (1973a) Intertemporal Capital Asset Pricing Model, that state variables in addition to market risk are priced.