A Novel Approach to Asset Pricing: Pair-Wise (or Janus) Equilibrium

Abstract

An effective asset pricing model should provide consistent recommendations for asset pricing, asset allocation and measuring risk-adjusted performance (or the “three facets of investing”). This paper incorporates three critical realities of investing (i.e., that investors have many stochastic goals, seek to delegate to skillful agents, and maximize risk-adjusted returns as opposed to expected utility), which in turn results in a pair-wise equilibrium, and a very different normative approach to asset pricing. The model uses observable assets for the asset pricing model (as opposed to a single factor or multiple factors), articulates an explicit return for the absolute risk free asset (as opposed to treating it as exogenous), captures the impact of substitutes and “complements” (in turn requiring inputs to be internally consistent), and provides consistent asset allocation recommendation and risk-adjusted performance measures. It also offers a new way to think about a heterogenous investor model for asset pricing.

Keywords: Pair-wise Equilibrium, GRAPM, Goals Based Investing, Asset Pricing, Asset Allocation, Risk-Adjusted Performance, Heterogeneous Investors, GBI, CAPM, RAPM, Three Fund Separation, Zeta, Relative Beta, Goal-Replicating Assets, SeLFIES, BFFS, BEST, M-cube, M-square, Sharpe Ratio, Janus Equilibrium

JEL Classification: G1, G2, G12