Academic journal article International Journal of Business

An Intertemporal Capital Asset Pricing Model under Incomplete Information

Academic journal article International Journal of Business

An Intertemporal Capital Asset Pricing Model under Incomplete Information

Article excerpt

I. INTRODUCTION

The capital asset pricing model of Sharpe-Lintner-Mossin, CAPM, is regarded as one of the most common developments in modern capital market theory. The CAPM model is still subject to theoretical and empirical criticism. In fact, since the model assumes the mean-variance criterion, it is subject to all the well-known theoretical objections to this criterion.

Merton (1973) develops an equilibrium model of the capital market. He shows that portfolio behavior for an intertemporal maximizer will be different when he faces a changing investment opportunity set instead of a constant one. Merton's intertemporal model is based on consumer investor behavior and captures effects, which would never appear in a static model. These effects cause significant differences in specification of the equilibrium relationship among asset yields that appears in this model and the classical model.

By relaxing the main assumptions used in the CAPM, the model has been extended to more general economies. Merton's (1973) model states that the expected excess return on any asset is given by a "multi-beta" version of the CAPM with the number of betas being equal to one plus the number of state variables.

In the same context, Breeden (1979) shows that Merton's multi-beta pricing equation can collapse into a single beta equation where the expected excess return on any security, is proportional to its beta, with respect to aggregate consumption alone. Since the acquisition of information and its dissemination are central activities in finance, and in capital markets, Merton (1987) develops a model of capital market equilibrium with incomplete information, CAPMI, to provide some insights into the behavior of security prices. He also studies the equilibrium structure of asset prices and its connection with empirical anomalies in financial markets.

Merton's (1987) model is a two period model of capital market equilibrium in a costly economy where each investor has information about only a subset of the available securities. The key behavioral assumption is that an investor considers including security S in his portfolio only if he has some information on this security. Information costs have two components: the costs of gathering and processing data, and the costs of information transmission. This problem is related to the literature on the principal-agent problem, to the signaling models, to the differential information models and to the theory of generic and neglected stocks.

Merton's model, the CAPMI, is an extension of the CAPM to a context of incomplete information. As Merton explains "Even modest recognition of institutional structures and information costs can go a long toward explaining financial behavior ...", the model also gives a general method for discounting future cash flows under uncertainty. Note that under complete information, the CAPMI model reduces to the standard CAPM.

Financial models based on complete information might be inadequate to capture the complexity of rationality in action. Some factors and constraints, like entry into the dealer business are not costless and may influence the short run behavior of security prices. Hence, most models developed in financial economics do not explicitly provide a functional role for the complicated and dynamic system of dealers, market makers and traders.

Besides, the treatment of information and its associated costs play a central role in capital markets. If an investor does not know about a trading opportunity, he will not act to implement an appropriate strategy to benefit from it. However, the investor must determine if potential gains are sufficient to warrant the costs of implementing the strategy.

From Merton's model (1987), it appears that taking into account the effect of incomplete information on the equilibrium price of an asset is similar to applying an additional discount rate to this asset's future cash flows. …

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