The Machinery of Asset Pricing and Its Implications

Abstract

The assumption that final investor/consumers maximize intertemporal utility supports an asset pricing theory that is both elegant and intuitive. Unfortunately, the assumption is counterfactual. Final investors/consumers with few exceptions lack the capacity to operationalize the model. More to the point, they don’t try. Instead, investment decision making is delegated via a complex structure involving numerous layers of investment professionals in addition to regulators and the financial media. Based on a high level empirical investigation, we argue that the marginal investors are active fundamental managers who base investment decisions on a comparison of market price with discounted cash estimates of fundamental value. This turns out to have provocative implications for asset pricing. In particular, the cross section of expected returns is determined by the models that the marginal investors use for estimating the discount rate in their DCF valuations. This leads to a feedback relation between asset pricing theories and the asset prices the theories describe that warrants further investigation.

Keywords: Asset pricing

JEL Classification: G12