Working Paper Series no. 223: Econometric Asset Pricing Modelling

Abstract

The purpose of this paper is to propose a general econometric approach to no-arbitrage asset pricing modelling based on three main ingredients: (i) the historical discrete-time dynamics of the factor representing the information, (ii) the Stochastic Discount Factor (SDF), and (iii) the discrete-time risk-neutral (R.N.) factor dynamics. Retaining an exponential-affine specification of the SDF, its modelling is equivalent to the specification of the risk sensitivity vector and of the short rate, if the latter is neither exogenous nor a known function of the factor. In this general framework, we distinguish three modelling strategies: the Direct Modelling, the Risk-Neutral Constrained Direct Modelling and the Back Modelling. In all the approaches we study the Internal Consistency Conditions (ICCs), implied by the absence of arbitrage opportunity assumption, and the identification problem. The general modelling strategies are applied to two important domains: security market models and term structure of interest rates models. In these contexts we stress the usefulness (and we suggest the use) of the Risk-Neutral Constrained Direct Modelling and of the Back Modelling approaches, both allowing to conciliate a flexible (non-Car) historical dynamics and a Car R.N. dynamics leading to explicit or quasi explicit pricing formulas for various derivative products. Moreover, we highlight the possibility to specify asset pricing models able to accommodate non-Car historical and non-Car R.N. factor dynamics with tractable pricing formulas. This result is based on the notion of (Risk-Neutral) Extended Car process that we introduce in the paper, and which allows to deal with sophisticated models like Gaussian and Inverse Gaussian GARCH-type models with regime-switching, or Wishart Quadratic Term Structure models.

Henri Bertholon, Alain Monfort and Fulvio Pegoraro
October 2008

Classification JEL : C1, C5, G12

Keywords : Direct Modelling, Risk-Neutral Constrained Direct Modelling, Back Modelling, Internal Consistency Conditions (ICCs), identification problem, Car and Extended Car processes, Laplace Transform.