Chapter 11 Intertemporal asset pricing theory

This is a survey of the basic theoretical foundations of intertemporal asset pricing theory. The broader theory is first reviewed in a simple discrete-time setting, emphasizing the key role of state prices. The existence of state prices is equivalent to the absence of arbitrage. State prices, which can be obtained from optimizing investors' marginal rates of substitution, can be used to price contingent claims. In equilibrium, under locally quadratic utility, this leads to Breeden's consumption-based capital asset pricing model. American options call for special handling. After extending the basic modeling approach to continuous-time settings, we turn to such applications as the dynamics of the term structure of interest rates, futures and forwards, option pricing under jumps and stochastic volatility, and the market valuation of corporate securities. The pricing of defaultable corporate debt is treated from a direct analysis of the incentives or ability of the firm to pay, and also by standard reduced-form methods that take as given an intensity process for default. This survey does not consider asymmetric information, and assumes price-taking behavior and the absence of transactions costs and many other market imperfections.