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Rational-investor theory

Theory based on the assumption of rational investor behavior has a long tradition in asset pricing, as in other fields of economics. In essence, it links the stochastic discount factor to investor behavior through assumptions about preferences. By assuming that investors makeportfolio decisions to obtain a desired time and risk profile of consumption, the theory provides a link between the asset prices investors face in market equilibrium and investor well-being. This link is expressed through �, which captures the aspects of utility that turn out to matter for valuing the asset. Typically, the key link comes from the time profile of consumption. A basic model that derives this link is the CCAPM.3 It extends the static CAPM theory of individual stock prices by providing a dynamic consumption-based theory of the determinants of the valuation of the market portfolio. CCAPM is based on crucial assumptions about investors’ utility function and attitude toward risk, and much of the empirical work has aimed to make inferences about the properties of this utility function from asset prices.The most basic version of CCAPM involves a “representative investor” with time-additive preferences acting in market settings that are complete, i.e., where there is at least one independent asset per state of nature. This theory thus derives � as a function of the consumption levels of the representative investor in periods t+1 and t. Crucially, this function is nonlinear, which has necessitated innovative steps forward in econometric theory in order to test CCAPM and related models. These steps were taken and first applied by Hansen. In order to better conform with empirical findings, CCAPM has been extended to deal with more complex investor preferences (such as time non-separability, habit formation, ambiguity aversion and robustness), investor heterogeneity, incomplete markets and various forms of market constraints, such as borrowing restrictions and margin constraints. These extensions allow a more general view of how � depends on consumption and other variables. The progress in this line of research will be discussed in Section 5.

Behavioral finance

Another interpretation of the implied fluctuations of � observed in the data is based on the view that investors are not fully rational. Research along these lines has developed very rapidly over the last decades, following Shiller’s original contributions beginning in the late