Information Costs and the Economics of Asset Pricing

All investors bear information costs. Each portfolio contains a limited number of securities, which occurs at the point where the gain from diversifying to one more security just offsets the loss from spreading information costs over an additional security. The securities in the portfolio chosen by the investor are all of identical riskiness, with investors sorting to securities of their individual desired level of riskiness. A stability condition governs the shape of the market risk-return relation derived from the foregoing portfolio theory. The first derivative of the risk-return relation is positive and declining. The portfolio theory is used to derive the condition that the second derivative is the ratio of the density of security supply to the density of security demand at each level of riskiness and ensures that incremental demand equals incremental supply at each level of riskiness. A preliminary estimate of the risk-return relation is estimated using historical U.S. data. It gives common sense results consistent with the functional form suggested by the theory, with no equity premium puzzle. In a macroeconomic model, the interest rate paid is an endogenous choice of the household.

An explanation of asset pricing is developed based on aggregating the portfolio choices of individual investors. Recognition is given to investor information costs. Portfolio risk is lowered by increasing the number of securities an investor holds, giving Markowitz-type diversification gains. Investigation costs required for any additional security raises costs. Investigation costs are pushed to the point where the marginal gain from diversifying to one more security just offsets the marginal loss from spreading information costs over an additional security. The same comparison of marginal cost and marginal gain of adding a security applies to each security being considered for inclusion. The result is that every security in the portfolio chosen by the investor is of identical riskiness. Investors sort to securities of their individual desired level of riskiness. Each investor holds only a small fraction of the total number of securities. They are in competition to buy the total supply of securities. Prices must be such that the market for all securities clears. As investors jockey for position in holding securities of varying riskiness, they will make bids only against those who have chosen securities of a similar risk level, since investors who have different risk preferences will be competing for securities of a different riskiness. While the investors will be ranked with riskier securities commanding higher returns, there are many ways of ranking securities in such an order. The impasse between competing investors is broken by the relative change in slope i.e. the relative change in rise in riskiness, or change as given by the second derivative of the risk-return relation as riskiness increases. Market stability requires that the second derivative of the market risk relation is negative. The demand parameters of individual investors must be brought in, in such a way as to conform to the risk return slope conditions for the risk return relation, and these need to be related to the supply conditions for securities to ensure that demand and supply for securities at each level of security riskiness are equal. The derivative of the slope of the risk return relation is equal to the absolute value of the ratio of density of supply to density of demand at that level of riskiness. Expected return r is expected return on the least risky security r0 plus the integral of the slope dr/dR from that of the least risky security up to that of the security in question: r=r0+R0R{(dr/dR)0+R0R[-j(R)/h(dr/dR)dR]dR}dR This result is for the case where investors differ in risk aversion but their information cost functions are identical, as may be reasonable where brokers and other intermediary investors draw on similar pools of security analysts. The case of investors with dissimilar information cost functions is briefly considered as a prelude to explaining security market fluctuations and disequilibria. The next part of the study embeds the asset pricing explanation of this book in a Lucas-type macroeconomic model. The asset pricing explanation developed in this book still applies, subject to the proviso that the least risky security held by any investor conforms to the Euler equation for optimal saving. The effects of risk on saving are explored, bringing out that the saving decision of the household is an endogenous choice. Next the relation of the explanation of asset prices in this book to consumption capm is explored. In consumption capm every investor holds every asset, whereas in this book each investor holds only a few assets. Our explanation encounters no equity-premium puzzle. Using historical U.S. data, we make a preliminary estimate of the long run risk return relation for the U.S. It has common sense appeal and paves the way for more refined estimation.

Dr. Tolley is Professor Emeritus of Economics at the University of Chicago and is also President of RCF Economic & Financial Consulting, Inc. Dr. Tolley received a Ph.D. in Economics from the University of Chicago, an M.A. in Economics from the University of Chicago, and a B.S. in Economics from American University. Dr. Tolley's published works include 22 books and over 50 articles. Among the journal articles, eleven were published in: the American Economic Review, Econometrica, the Journal of Political Economy, and the Quarterly Journal of Economics. He has participated in the preparation of 25 monographs and technical studies, and over 80 chapters contributed to books, conference proceedings, and other research studies. Dr. Tolley has held executive positions in the Federal Government, including Deputy Assistant Secretary of the Treasury for Tax Policy and Director of the Economic Development Division of the Economic Research Service of the U.S. Department of Agriculture. Dr. Tolley was Director of the Center for Urban Studies at the University of Chicago from 1978 to 1985. He has held visiting professorships at Purdue University, the University of California at Berkeley, Nankai University, and Guelph University. Dr. Tolley is a Fellow of the American Association for the Advancement of Science (AAAS). He has served on committees of the National Research Council of the National Academy of Sciences. He is a founding editor and now honorary editor of the Elsevier professional journal Resources and Energy. He is the recipient of an Honorary Doctoral degree from North Carolina State University. He is the recipient of an honored colleague award of the Society for Benefit-Cost Analysis. Dr. Tolley has made important original academic contributions. He is a pioneer in the areas of Environmental, Urban, and Energy Economics. Among his accomplishments, Dr. Tolley long has been an internationally recognized leader in the development and application of techniques for measuring costs and values that are determined outside of conventional markets. He has applied these techniques to the valuation of environmental amenities and costs, urban housing, value of life and medical treatments, among others. He has used such estimates successfully in court cases and regulatory proceedings. This book grows out of his experience as Deputy Assistance Secretary of the Treasury.