INTRODUCTION

This chapter studies the two main financial building blocks of simulation models: the consumption-based asset pricing model and the definition of asset classes. The aim is to discuss what different modelling choices imply for asset prices. For instance, what is the effect of different utility functions, investment technologies, monetary policies and leverage on risk premia and yield curves?

The emphasis is on surveying existing models and discussing the main mechanisms behind the results. I therefore choose to work with stylised facts and simple analytical pricing expressions. There are no simulations or advanced econometrics in this chapter. The following two examples should give the flavour. First, I use simple pricing expressions and scatter plots to show that the consumption-based asset pricing model cannot explain the cross-sectional variation of Sharpe ratios. Second, I discuss how the slope of the real yield curve is driven by the autocorrelation of consumption by studying explicit log-linear pricing formulas of just two assets: a one-period bond and a one-period forward contract.

The plan of the chapter is as follows. Section 2 deals with the consumption-based asset pricing model. It studies if the model is compatible with historical consumption and asset data. From a modelling perspective, the implicit question is: if my model could create a realistic consumption process and has defined realistic assets (for instance, levered equity), would it then predict reasonable asset returns? Section 3 deals with how assets are defined in simulation models and what that implies for pricing. I discuss yield curves (real and nominal), claims on consumption (oneperiod and multi-period), options and levered equity. Section 4 summarises the main findings. Technical details are found in a number of appendices (p. 444).

PROBLEMS WITH THE CONSUMPTION-BASED ASSET PRICING MODEL

This part of the chapter takes a hard look at the consumption-based asset pricing model since it is one of the building blocks in general equilibrium models. The approach is to derive simple analytical pricing expressions and to study stylised facts – with the aim of conveying the intuition for the results.

The first sections below look at earlier findings on the equity premium puzzle and the risk-free rate puzzle and study if they are stable across different samples (see the surveys of Bossaert 2002; Campbell 2001; Cochrane 2001; and Smith and Wickens 2002).