We derive a closed-form solution for the optimal portfolio of a nonmyopic utility maximizer who has incomplete information about the alphas or abnormal returns of risky securities. We show that the hedging component induced by learning about the expected return can be a substantial part of the demand. Using our methodology, we perform an "ex ante" empirical exercise, which shows that the utility gains resulting from optimal allocation are substantial in general, especially for long horizons, and an "ex post" empirical exercise, which shows that analysts' recommendations are not very useful.

We provide a framework in which we link the valuation and asset allocation policies of defined benefits plans with the lifetime marginal productivity schedule of the worker and the pension plan formula. In turn, we examine the retirement policies that are implied by the primitives of the model and the value of pension obligations. Our model provides an explicit valuation formula for a stylized defined benefits plan. The optimal asset allocation policies consist of the replicating portfolio independent of the pension liabilities. We show that the worker with retire when the ratio of pension benefits to current wages reaches a critical value which depends on the parameters of the pension plan and the discount rate. Using numerical techniques we analyze the feedback effect of retirement policies on the valuation of plans and on the asset allocation decisions.

This paper tests the cross-sectional implications of “keeping-up-with-the-Joneses” (KUJ) preferences in an international setting. When agents have KUJ preferences, in the presence of undiversifiable nonfinancial wealth, both world and domestic risk (the idiosyncratic component of domestic wealth) are priced, and the equilibrium price of risk of the domestic factor is negative. We use labor income as a proxy for domestic wealth and find empirical support for these predictions. In terms of explaining the cross-section of stock returns and the size of the pricing errors, the model performs better than alternative international asset pricing models.

We show that benchmark-linked convex incentives can lead risk-averse money managers aware of mispricing to overinvest in overpriced securities. In the model, the managers’ risk-seeking behavior varies in response to the interaction of mispricing with convexity and benchmarking concerns. Convexity effects can exacerbate the manager’s overinvestment in overvalued nonbenchmark securities. In contrast, they potentially offset the benchmarking effects studied in the literature, leading to underinvestment in overpriced benchmark securities. Under correlated mispricing across assets, our model rationalizes positive positions in nonbenchmark, negative risk premium (i.e., “bubble”) securities and “pairs trading” in two overvalued securities. Our findings help explain several empirical puzzles.

This paper analyzes asset prices in a representative agent exchange economy with habit-forming preferences. For a general class of utility indices and endowment processes, the authors characterize the optimal demand for consumption and derive explicit solutions for the interest rate and asset risk premia. They show that consumption smoothness may obtain even when the interest rate is stochastic. The consumption capital asset pricing model may not hold when the endowment process has stochastic coefficients; asset risk premia are larger under mild assumptions. The interest rate depends on the growth in the standard of living. Malliavin calculus is employed in the analysis. Copyright 1991 by The Econometric Society.

The finance literature documents a relation between labor income and the cross section of stock returns. One possible explanation for this is the hedging decisions of investors with relative wealth concerns. This implies a negative risk premium associated with stock returns correlated with local undiversifiable wealth because investors are willing to pay more for stocks that help their hedging goals. We find evidence that is consistent with these regularities. In addition, we show that the effect varies across geographic areas depending on the size and variability of undiversifiable wealth, proxied by labor income.

ABSTRACT This paper tests the cross‐sectional implications of “keeping‐up‐with‐the‐Joneses” (KUJ) preferences in an international setting. When agents have KUJ preferences, in the presence of undiversifiable nonfinancial wealth, both world and domestic risk (the idiosyncratic component of domestic wealth) are priced, and the equilibrium price of risk of the domestic factor is negative . We use labor income as a proxy for domestic wealth and find empirical support for these predictions. In terms of explaining the cross‐section of stock returns and the size of the pricing errors, the model performs better than alternative international asset pricing models.

We study the incentive effects of granting levered or unlevered stock to a risk-averse manager. The stock is granted by risk-neutral shareholders who choose leverage and compensation level. The manager applies costly effort and selects the level of volatility, both of which affect expected return. The results are driven by the attempt of the risk-neutral shareholders to maximize the value of their claims net of the compensation package. We consider a dynamic setting and find that levered stock is optimal for high-type managers, firms with high momentum, large firms, and firms for which additional volatility only implies a modest increase in expected return.

We introduce a model that captures the main properties that characterize employee stock options (ESO). We discuss the likelihood of early voluntary ESO exercise, and the obligation to exercise immediately if the employee leaves the firm, except if this happens before options are vested, in which case the options are forfeited. We derive an analytic formula for the price of the ESO and in a case study compare it to alternative methods. Since the mid-1980s, stock options have been a substantial component of com-pensation packages for employees. For example, in 1999, 94 % of companies in the S&P 500 offered stock options to their top employees (see Murphy, 1999; Hall and Murphy, 2002). In 1995, the Financial Accounting Standards Board (FASB) (with FAS 123) set a standard that required firms to expend stock-based compensation at the moment the compensation was granted (see FASB, 1995). Firms were encour-aged to use the “fair value ” of the stock option to compute the value of the compensation, but were allowed to use the “intrinsic value”—market price of the stock minus strike price. Since employee stock options (ESOs) are typically granted at the money, the intrinsic value is zero, which results in no expense recorded at the time of the grant, and this is probably one of the reasons that helped their popularity.

We derive a closed-form solution for the optimal portfolio of a nonmyopic utility maximizer who has incomplete information about the alphas or abnormal returns of risky securities. We show that the hedging component induced by learning about the expected return can be a substantial part of the demand. Using our methodology, we perform an “ex ante” empirical exercise, which shows that the utility gains resulting from optimal allocation are substantial in general, especially for long horizons, and an “ex post” empirical exercise, which shows that analysts’ recommendations are not very useful. (JEL C61, G11, G24)