Introduction

These notes are an introduction to two extremes in the continuum of asset pricing models. The first model, the Lucas Tree model of Lucas (1978) looks at asset prices from a very high level, abstracting away (through the use of general equilibrium) the mechanism that generates prices, and thus allowing the modeler to focus on the behavioral (i.e. preference) components of market participants. It is a workhorse for modern finance because it can be used to understand the profit motive of investors, the importance of risk aversion and the (related) demand for diversification by investors, among other important phenomena. However, the Lucas model is quite difficult (and often intractable) when dealing with investors who have heterogeneous beliefs or preferences and, since it typically relies at least in part on consumption data, its use at frequencies higher than monthly has been less extensive.

The second model, elaborated by Kyle (1985), focuses on the specifics of the generation of market prices. By focusing on the market making process, it provides insight into what it means for the price of an asset to be the value \(P\), and how that price changes in the short term if the information available to traders changes. It is also a commonly used model because it allows for heterogeneous information amongst traders, takes the price generation process seriously and can be applied to asset price data even at very high frequencies. However, it is fundamentally a static model so the only link between prices intertemporally is information. It is silent (at least in its most commonly used form) on the role of risk aversion and diversification and does not attempt to link investment strategy with a broader household objective function, beyond the assumption that investors maximize expected profit.

I discuss these two models by focusing on the question ``What empirical facts can we learn about people by studying the prices of assets that we observe in the market.’’ Personally, I find this to be one of the most interesting questions in economics, and a prerequisite to understanding how to make good policy or make money in the marketplace.

In the marketplace, mutual funds, hedge funds and high-frequency traders must, beyond their study of the properties of the companies whose stocks they trade, also understand how individuals, households and institutions will react to new information, new regulatory environments and new market structures. Despite what is sometimes suggested in the popular press, the only incontrovertable truth about asset prices is that they are determined by supply and demand. A money manager hoping to understand how prices will move must understand how the properties of human participants affect the demand for those assets.

Similarly, a policy maker cannot hope to make effective policies without understanding the nature of the people who will be affected by them. Recent policy debates about (inter alia) market circuit breakers, incentivizing long-term saving through differing long- and short-term capital gains tax rates and the question of privatizing social security rely on the kinds of answers that can be had from an in-depth study of these two models.