On Equilibrium Asset Price Processes Hua He Hayne Leland University of California, Berkeley In this article we derive necessary and sufficient conditions that must be satisfied by equilibrium asset price processes in a pure exchange economy. We examine a world in which asset prices follow a diffusion process, asset markets are dynamically complete, all investors maximize their (state-inde- pendent) expected utility of consumption at some future date, and investors have nonrandom exog- ‘enous income. We show that it is necessary and sufficient that the coefficients of an equilibrium difusion price process satisfy a partial differen- Hal equation and a boundary condition. We also examine bow the dynamics of asset prices are related to the shape of the representative inves- tor’s utility function through the boundary con- dition. For example, in a constant-volatility econ- ‘omy, the expected instantaneous return of the market portfolio is mean reverting if and only the relative risk aversion of the representative investor is decreasing in terminal wealth. In this article we derive necessary and sufficient con: ditions that must be satisfied by equilibrium asset price processes in a pure exchange economy. We “Thisaricc ra jevned vaso an carer one ended Eulibiom Ase Prce Proves Wethank sem nat panipantsat HEC, Uc Betkley, UCLA Univers of Mines, and the University of Pennsyvana Wharton f° Felptrcomments fe sesso grateful eo the rteree @- Maeswaran) ahd itor Pil Dybvig oe sary help! comments and suggestions abd hank Execute edo Chester sput for estonia suggestions Financial support {fom the baterynarch Fellowship Progr (lr Hua We) and the Berkeley Tropes in Fiance is ately scnowiedged. Address proofs and veprin fequestt to Hus He, Haas schol of Business, UnWersity of Calor at Berkeley, Berkeley, Ca 98720 eve of Fnac sae 93 ou camer 3p. 98 607 GET Review of tna Ses m5 9849370150‘The Review of Pmanctel Studes/ 6m 31995 examine a World in which asset prices follow diffusion process, asset markets are dynamically complete, all investors maximize theie (state independent) expected utility of consumption at some future date, and investors have nonrandom exogenous income. The assumption of dynamically complete markets allows us to work ina representative investor framework [see Constantinides (1982)} We show that for a diffusion process to be an equilibrium asset price process of the market, it is necessary and sufficient that the Coelicients of the diffusion process satisfy a partial differential equa tion and a boundary condition. The partial diferential equation is derived from the fact that the representative investor optimally holds the market portfolio and therefore follows a path-independent strat egy. We also examine how the dynamics of asset prices are related to the shape of the representative investor's utility function through the boundary condition. For example, in a constantvolatility econ omy, the expected instantaneous return of the market portfolio i mean reverting if and only if the relative-risk aversion of the repre sentative investor is decreasing in terminal wealth, ur assumptions of diffusion processes for asset prices and state independent utility functions for investors are common in the finance literature: see Merton (1971, 1973) and Breeden (1979). Economies with dynamically complete markets have also been widely studied, as illustrated in Black and Scholes (1973). The assumption of non random exogenous income is special but later will be weakened. The results of this article supplement those of the international capital asset pricing models (ICAPM) developed by Merton (1973) and extended by Breeden (1979). These models assume that asset prices and a vector of exogenously specified state variables follow a multidimensional diffusion process. With this assumption, equilib rium conditions are then imposed that restrict the expected instan taneous returns of individual assets relative to the expected instan taneous return of the market portfolio. Since the ICAPM emphasizes only the relative pricing between individual assets and the market portfolio, these models have not provided a full characterization of the asset price processes consistent with a market equilibrium? With ur (additional) assumptions of the economy, we are able to provide complete characterization of equilibrium price processes. \ iuang (989) provides a theorstialfoundstion for dhe system of cqullbrium prises and sate ‘rales to forma difusion process in a pure exchange economy The suclent conctios involve “crainpoenie oft ry fonctions he gate coe pres andthe Send Robinsein (1976), Breeden and Lizenberger (1979), and Beeasan (1979) have shows that 2 Jgnormal proces for the maket portfolio le comsetemt sith a representative investor ng Constant relative ask sverson. Genhote and Mah (1998) extend the analyse allow anda ‘olutity ofthe dividend peocess te pie proces po longer feats formal 594gar Brice Processes Our article is closely related to Bick (1990), who also presents a set of necessary and sufficient conditions for a diffusion price process to be supported by an economy similar to ours. But, oue approach is quite different from, and simpler than that of, Bick. In order to verify thata given process is an equilibrium process, Bick’s approach involves computing the conditional expectations of the marginal utility of consuming the terminal value of assets at the final date, which could be very difficult to calculate if the conditional density function does rnot have an analytical form. However, in the special case where asset prices are time-homogeneous diffusions, Bick simplifies his condi tions so that computing conditional expectations is no longer required. Our necessary and sufficient conditions in this special case are the same as Bick’s Ourarticle is also related to Wang (1991), who studies equilibrium conditions for asset price processes in an economy similar to ours, except that Wang allows intermediate consumption. Wang's approach, relies upon the existence of a solution to a certain differential equa tion, an approach that is also different from ours. While Wang derives a set of sufficient conditions for a given price process to be an equi librium process, these conditions are much stronger than necessary. Therefore, a complete characterization of equilibrium price process is not provided. However, we can apply our approach to Wang's economy to get conditions that are both necessary and sufficient. “The rest of the article is organized as follows. Section 1 formulates 4 continuous-time securities market-pure exchange economy in a single representative investor setting, Section 2 derives the necessary and sufficient conditions for a diffusion price process of the market to be an equilibrium in our economy. Examples are also provided to illustrate these conditions. In Section 3 we examine an economy in which the volatility of asset returns is a constant. Section 4 contains some concluding remarks |. Formulation Consider a continuous-time dynamically complete securities market pure exchange economy in which there is a single representative investor who has a finite lifetime horizon (0, T). There is one risky stock and one riskless bond available for trading at any time between 0 and T. The risky stock can be viewed as the market portfolio, the total supply of which is normalized to one share. The riskless bond adie slowed arbi tate depnde wiliyTancions or arian exogenous income pee then arotraryarsuage tee pice seme cid be sopponed by competsve equllium see expe (1981), 595The Review of Financial Staies/» 6m 31993 is viewed as a financial asset, which is in zero net supply.* We assume that the price process for the stock S is a diffusion process and can be deseribed by the stochastic differential equation so = USO, drt oS, aw), te (0, TC) where 4 and ¢ are twice continuously differentiable with respect to Sand continuously differentiable with respect to #, and wis a standard Brownian motion defined on a complete probability space (0, P. F).* It is assumed that ¢ > 0 almost surely and that the stock price is strictly positive with probability 1. Thus, each w € @ specifies a com- plete history of the Brownian motion as well as the stock price. We assume that the stock pays no dividends. To avoid the potential dif ficulty of classifying boundary behavior, we further assume that Scan take values on the entire positive real line and S cannot be negative. For simplicity, the equilibrium interest rate for the bond is taken to a constant, r° The representative investor is assumed t0 have access. only to the information contained in the historical prices, which can be modeled by the o-field generated by F, = 4{S(3); 0 = $= #} for ¢ € (0, T] with F =F, ‘We assume that there exists an equivalent martingale measure or a risk-neutral probability Q for the stock price process considered in (2), This equivalent martingale measure is defined as 014) = fete, Med) vaER @ «See Remark 1(@) forthe case witha pastve bt supp Othe Fess bond implicit in his the assumption that 2 solution tothe tochastie diferent equation (1) exis ‘heasumonsa ein pce aces he woke dion prs eee Toma set of move pramive azsumpaogs, For example, one can ew the Nock 2 eal 0 a8 trndowmen oF erp tobe reed at she Ral date 11 where de cndowment i taken € Be 2 ‘mcrae god" scot endorest cop ellowssifsion proces se(0) mals 9 at BL, 9 del we assume that 2(0) is obverable (othe Investor a me # aed that the Evestog as avon ‘Neumann Morgenstern, sate independent wlty function, den the equim sock pice Pro ‘eve must bea function of rand Fund, consequently shoul have the forms asumed here. See Mona (1967) foe one details Wang (991) works dicty 9th te condi tat the eu Dice shouldbe a funcion of and provides sullen conditions for this function to hecome an ui pie Since thee is no intermediate consumption jn dur model the rishless intrest ete cannot be ‘deteroined in equifnum and ie thertore specibed exogenously Se Hasson and Kreps (1979) forthe femer and Cox an Hos (1976) fr the ae. 596quiere ice Process where veo off ase, 1 f'(ucsio,) = 2 f ( ase, ) @ ‘The Fw, Ne~ can also be interpreted a5 the Arrow-Debreu state price (at time 0) per unit of probability for one unit consumption ood to be received at state w and time £, We will sometimes call EC} state prices without mentioning interest rate discounting and per unit of probabilty. Under the equivalent martingale measure Q, the stock price dynamics becomes as KO} rdt + o(S(t), ) dwr(t), where w*(t) = w(t) + Jf (u(s) — r)/o(s) dsis a standard Brownian motion under Q. Given our current setup, the equivalent martingale measure must be unique (see Harrison and Kreps (1979)} ‘We consider a representative investor who consumes only at the final date* and whose preferences for consumption at the final date can be represented by the expected utility of a von Neumann-Mor- xgenstern, state-independent utility function EUCW(7)), where W(T) denotes the wealth at the final date, and U is twice continuously differentiable, increasing, and concave. For now, we assume that the representative investor does not receive any exogenous income,’ is endowed with one unit ofthe stock at time 0, and is allowed to allocate tthe wealth between the stock and the bond so that he maximizes the expected utility of consuming the final wealth atthe final date. That is, he solves the dynamic consumption and investment problem sup EU(W(T)) st. dW) = WD + AMUSO, ~ 9) dt + A@a(S, 0 dw, (0, Th WO ZO, 160, 7}, w where AC) denotes the dollar amount invested in the stock at time. . The first constraint in (4) is the dynamic budget constraint deter mining the evolution of the wealth process. The second constraint in (4) is the nonnegative wealth constraint, which rules out the pos: + We wil dies the coc of ftermediateconsumpuon in Secon 2 © we wil zl thie asumption a Section 2 597The Review of Financial Stuer 6 31993 sibility of creating something out of nothing {see ybvig and Huang, (1988)]. 4 dynamic investment strategy is said to be an equilibrium investment strategy if it requires that the investor optimally invest all the wealth in the risky stock at each moment in time and consume the terminal value of the stock at the final date. In this ease, the stock. price process considered in (1) is said to be an equilibrium in our economy. Our definition of equilibrium is stronger than what we usually mean by competitive equilibrium. Specifically, we have assumed that (is state-independent, the representative investor does not receive exog enous income, and consumption occurs at the final date 7: Thus, the class of asset price processes considered here is only a subclass of equilibrium asset price processes consistent with competitive equi: librium, . Characterization of Equilibrium Price Processes In this section we characterize equilibrium asset price processes for the economy specified in the previous section. The main idea of our analysis is to exploit the condition that in equilibrium the represen: tative investor follows a path-independent strategy (.e., holding the market portfolio). We derive necessary and sufficient conditions for a given price process to be an equilibrium in our economy. We also provide examples that show how our results can be used to identify equilibrium asset prices. Let Abe the investment function that solves the investor's dynamic consumption and investment problem, and let J (W, 5, #) be the value ofthe optimal objective function or the indirect utility function, given that the wealth and the stock price at time tare Wand 5, respectively. Assume that J is twice continuously differentiable with respect to W and Sand continuously differentiable with respect to for W> 0,5 > 0, and £€ (0, 7). Then, following Merton (1971, 1973), J must satisfy the Bellman equation 0 = max [J, + OW + Ale = D)Jw + HSI Jo°AJuw + 9°SAJus + $o°SJus, ©) for all W > 0,8 > 0, and ¢€ (0, 7), and the boundary conditions lim JW, 8, 9 = UC) and 10), where all subscripts denote partial derivatives. Note that the second boundary condition reflects the nonnegativity constraints on wealth ‘The first order condition implies that 598quirium Price Process WSO =r Se S OD _ Jus WS AES OTS DF Ful 5, 0 Feel W, 5," where the first term on the right-hand side is an instantaneous mean- variance efficient portfolio, and the second term represents the hed. ing demands against adverse changes in the consumption-investment opportunity set. In equilibrium, we have ACS), SD, 9 = SD, because there is only one unit of the stock available for trading, We should restrict our attention only to those price processes and utility functions so that J are continuously differentiable with respect to W and Sup tothe fourth order and that J, Jw» Jew, aNd Juste continuously differentiable with respect {0 ¢ This allows us to work with many derivatives of the indirect utility function, Differentiating (5) with respect 10 W gives 0 = Jur t thw + (FW + Alu ~ Jue + Bes © + 107A ewe + A0*SJwus + 10° Jessy where we have used (6) to simplify terms. This equation implies that the drift of je is —r/». The diffusion term of dj is JyweA + Jao, which equals ~((u — r)/0) Ju by (6). We conclude that JAW, SO, 0) _ ws, 0 ry dt aS@, D Juf WUD), SO, D dwt). Solving this stochastic differential equation gives Ih WO, 8, 1D = siore-reno| aaa s) 7 ‘u(sts), 3) =r) “HS Sets) 4 = Jel E(DEm", where Jy(0) = Jy( W(0), S(0), 0) and &(2) is defined in (3). Since in equilibrium the representative investor holds one share of the risky stock, we have W(t) = S(t) and Jah SC) SDD = Ju S1O),S(0) OEE ‘The previous equilibrium condition implies that the Arrow-Debreu state price at time f, (1), must be path independent (i.e, independent 599The Review of Pmanctl Studes/v6n.3 1995 of the past history of stock prices) forall Since the state-price process at time f, (1), depends in general on the historical stock prices through the integral of (u ~ 1)/e with respect to dw, path indepen: dence clearly puts stringent conditions on and ¢. The equilibrium condition also implies that 0"(S(7)) = Jy(0)E(7)e~, which requires in equilibrium that holding the total supply of the risky stock be optimal and that the state price at time T and the stock price be inversely related. ‘The following theorem explores the foregoing discussion and pro- vides necessary and sulficient conditions for the stock-price process {o satisfy in equilibrium in our economy. Theorem 1. The necessary and sufficient conditions for {S, t€ [0, TI} defined in (1) to be in equilibrium in our economy with a single representative investor consuming at a fixed final date are as follows: (O (u, «) satisfies the partial differential equation WStfe + US H+ f+ SSF. +L -N where f{S, ) = (ulS, 0 ~ nats, 0 (ti) There exists an increasing and concave utility function Usuch that f satisfies the boundary condition LS, D = =8U(9)/0(8). 8) Remark 1. (A) If we let £ be the differential generator associated with $—that is, £(f) = !a'S%f. + wf—then (7) can be rewritten as Lf + f+ oo SAS. +f — f) =0. (B) Condition (i) is essentially equivalent to the condition that a(S, T) = r-To verify the existence of Uthat satisfies (8), itis sufficient to require that /(S, 7) = O forall § > Oand that f(a, 1)/-xis integrable on any closed interval in (0, 6) or, equivalently, f(e", 7) is integrable on any closed interval in (0, +40). The utility Function that satisfies (8) is determined by v1) = re0( fee «), s>0, where y and 5, are positive constants. Integrating both sides with respect to S yields the utility function U that satisfies (8). 600_ (C) Ifthe total supply of the riskless bond is strictly positive, say B> 0, then we have Jal SC) + Be, $0, 1) = Ju(SO) + B, $(0), EE: Obviously, fshall satisfy the same partial differential equation (7) with the boundary condition AS, 1) = ~SU"S + Ben/u(s + Ber) Proof We prove the necessity here, while leaving the proof for the suliciency to the Appendix. Define A(S(1), 2) = In fe(S(, S(O, 9 = In fe(S(0), $(0),0). Since Ju(#) = Je(O)E(H “in equilibrium, we have (SC), ) = In &() — rt. Hence, the drift and diffusion terms of db must be the same as those of d(ln (1) ~ 72). Applying [td's we obtain Jo°Stbys + MS, + b= — Hu N/a? — v, o8bs= —(u~ N/a, or, equivalently, Sb=—f ) JoAShey — herp + of + rt b= 0. (ao) Now, differentiating (9) with respect to Sand 4, we get bysS + by = ‘fo and Sh, = J, Hence, Sth, = —Sf; + f,and (10) becomes Fa Sh +P) — Swf taf rt by ay Next, differentiating (11) with respect to $ and substituting Sh =f into the resulting equation, we get (7). Finally, the boundary condition for fis obviously satisfied if we set t= Tin (6) . The partial differential equation (7) is an equilibrium condition imposed on the coefficients of the stock price process. The argument that is crucial to the derivation of this equation is the observation that bis a function of S(#) and but not of the history of S. Thus, (7) is equivalent to that the state price process at time f &(0), is path independent for all « Consequently, (7) guarantees that for any inves tor with a state-independent utility function, he will follow a path independent investment strategy. Cox and Leland (1982) have shown that any optimal investment strategy must be path independent if the stock-price process follows a lognormal process. Our result extends that of Cox and Leland to a more general class of diffusion processes. ‘The boundary condition (8) ensures that holding the total supply of the risky stock is optimal for an investor with a utility function 601The Review of ancl Stes /2 6m 3 1998 ‘Theorem 1 provides a complete characterization of equilibrium asset price processes within the family of diffusion processes. We brain this characterization by exploiting the equilibrium condition that the representative investor optimally holds the toral supply of the risky stock. Note that this characterization cannot be derived directly from the ICAPM. Consequently, our equilibrium conditions are stronger than those derived in the ICAPM. If we are given a pair of diffusion coefficients (4,@), then we can easily check whether it satisfies the necessary conditions of Theorem 1. If any of these necessary conditions is violated, then we can imme diately conclude that Scan never be an equilibrium in our economy. Theorem 1 also suggests that for a given volatility function @ and a given utility function U'the expected instantaneous excess-return function normalized by the volatility function, fis determined by a nonlinear partial differential equation subject toa boundary condition at f= T: Under some standard regularity conditions, the boundary value problem defined by (7) and (8) has a unique solution (see Friedman (1969). Thus, for given @ and U, one can derive f by solving the partial differential equation (7), which can then be used to find the expected instantaneous return function 4. Clearly, the expected instantaneous return function depends on the shape of the utility function in an important way through the boundary condition, Of course, in order for a price process to be an equilibrium process, we still have to make sure that S is strictly positive Similarly, for a given expected instantaneous return function m, we can rewrite (7) as, le oft Fhe sip Aor Pp -p=0. a2) f “Thus, we can alternatively solve (12) for fand thereby find the vol atilty function ¢, In this case, we have to make sure that o? = (u ~ 1)/fis sticly positive, In summary, if we specily either the volatility function or the expected instantaneous return function, then the expected instantaneous return function of the volatility function can be determined by (7) or (12) and by the corresponding boundary condition. Theorem 1 suggests that for any given utility function, there exists a fairly large class of the expected instantaneous return and volatility functions that are consistent with our definition of equi librium. Equation (7) or (12) can be used to find systematically all of the equilibrium expected instantaneous return and volatility fune tions 602Bick (1990) has obtained a characterization of equilibrium or viable price processes for the same class of diffusion processes studied in this article. For a given pair of diffusion coefficients (1, 0), Bick con- structs the utility function in the same manner as we did in Remark 1 and shows that the price process Sis consistent with an equilibrium ifand only if SO = KU(SCD)SD)| F/O SOF, where F, denotes the information set generated from the historical stock prices. Therefore, in order to verify whether Sis consistent with aan equilibrium, we must compute conditional expectations. Since the conditional density functions are difficult to calculate in general, the necessary conditions derived in Propositions 1 and 2 of Bick (1990) ‘can hardly be verified for general diffusion processes, In contrast, the necessary conditions derived in Theorem 1 are easy to verify for any arbitrarily given diffusion process. Bick’s (1990) condition (P2) in Proposition 2 states that in equilibrium, for any 0. 4 <...< (4S Tand S$, Sy. ---1 8, > 0, Wy Sy fy SVC, Sy by Sa) ++ Cys Sorby Su) = Hy Se ty Sus where &( t,x; 5, 9) = pl, x5, 9)/qUt, x5, y), and p and gare the tran- sition density functions under probability measures Pand Q, respec tively. This condition is essentially equivalent to that & is path inde- pendent as dQ/dP = (7) ur approach is also quite different from that of Wang, who works directly with a dividend process and derives equilibrium conditions fon the function that maps from the value of current dividend to the asset price, However, Wang's general characterization of the equilib rium price contains an unknown utility function that makes it difficult to verify. By working directly with the dynamics of the equilibrium asset price process, we derive explicit conditions that are easy to verily ‘We now focus on an important subclass of diffusion processes that are of particular interest to financial economists, namely the class of time-homogeneous diffusion processes, asi) sO where @ = 0 and are functions of S. To check whether such a process is consistent with an equilibrium, one can verify whether f satisies (7). Since in this special case f is independent of t, oF f 0, (7) is equivalent to a(S) dt + b(S(D) dw, «aay 4 gy 2 f= Berk +P -S) =e. 603The Review of nancial Studios /0 6m 31993 ‘That is, there exists a constant K such that o'[Sf, + f° — f)= K. This is the same condition that Bick (1990) obtains in Proposition 3 for time-homogeneous diffusions. We summarize the necessary condi tions for this special case in the following corollary. Corollary 1. The necessary and sufficient conditions for {St, t€ [0, T)} defined in (13) 0 be consistent withan equilibrium are asfollows: () There exists a constant K such that oS t h-fak aay where f(S) = (w(S) ~ r)/0°CS). (i) There exists an increasing and concave utility function Usuch that f(S) = ~8U"(S)/U"(S). To illustrate the use of Theorem 1 and Corollary 1, we consider one example, More examples with time-homogeneous processes can be found in Bick (1990). Example 1. Assume r= 0. Consider the class of diffusion processes defined by BO a(n) dt + b dtd, ‘where Bs a constant and a = b, and f = a(S)/b*. Thus, OSfe + ft — f) = Sas a/b — a For the right-hand side of the equation to be a constant, it is necessary, at a function of S. We have w= a(S), 0 a(S) = atan(As~*) + 3b? for some @ > 0 and A> 0. Since we require a > 0, the second class Of solutions is not useful. For the first class of solutions, we requise asi It is important to point out that when we restrict the price processes to the class of time-homogeneous diffusion processes, the volatility function can be determined from the utility function. We can do th because fis now completely determined by the utility function that is, f= —SU"/U" and # = K(Sfet ff) 604Since K is a constant, the sign of Sf, +f — fmust be constant for all § > 0. This clearly puts further restrictions on the utility function, Specifically, it requires that the sign of —(d/ds) (U"(S)/U(S)) + ("(s)/U(S))? be constant for all $ > 0, as shown in Bick (1990) as well. For example, if U(S) = In $+ S!-*/(1 ~ a), then _ 4 (U0) , (OV _ aslo) * os) ~ For a > 2, the righthand side of this equation can change signs. Hence, there does not exist a time-homogeneous diffusion process that is consistent with our definition of equilibrium under such a utility function, Later, we demonstrate that there exists a non-time: homogeneous diffusion process for this utility function that is con sistent with our definition of equilibrium. Thus, in some cases, if one wants to identify the equilibrium price process for a given utility function, one may have to search among processes that are not time homogeneous. In summary, Theorem 1 has provided a general approach that characterizes the equilibrium asset price processes. There are a number of ways in which we can extend our result. First, we can allow intermediate consumption in our pure exchange economy (with no production). As it turns out, intermediate con: sumption does not have any significant effect on the characterization of equilibrium price processes as long as we specily the dividend process as a function of the current stock price and time. Let D() = D(S(2), 1) be the dividend process, and let satisfy ASC) = (UCSC, HSC) — D(S(), ) dt + a(S(D, DSC dw(0 If $ can be supported by utility functions (1, U), where u(x, #) and U(2) ate increasing and concave in x, w is the utility function for intermediate consumption and Ufor final wealth, then in equilibrium wWD(S(D, D) = Jul SC), SD, 1) = Jul SO), S(O), OCDE“. Defining has in the proof of Theorem 1, we have (a= n/a 1, o8b, = —(u ~ H/o fa®Sthy + (uS — D)by + by Eliminating h in the same way as before, we can show that (u, @) ‘must satisfy the partial differential equation Lf + f+ DISS + 05S, +f - [= 0, where Lf = J6Sif, + (uS ~ D)f. The boundary condition isthe same as in (8). When there is intermediate consumption, we should also 605The Kerk of Financial States 6» 3 1988 have W(DSO), 0) = JelOE DE Apply t6's lemma, we find that the utility function for intermediate consumption must satisfy ws, 0D WDSO, 0,0 Since 1 is concave, we require that (5, 1) = rfor all $ > 0 and te (0, 7) if the dividend rate is increasing in the level of stock price. ‘The above equation also suggests how one should be able to back out w by integration for given u, ¢, and D. Second, we point out that the class of diffusion processes we exam. ined here presumes that all relevant information to future returns is fully reflected in the current price.”” However, we can enlarge the class of equilibrium price processes to include It6 processes that have the form wS), 0 SOD (SH, = ast) Sey 7 Hi Dat + a(S, 9 dwt, where w is the entire stock price history rather than just the current stock price, We will show that in this case the equilibrium condition implies that « must depend only on the current stock price and not on the past history of stock prices. Therefore, even if we allow the expected return to depend on the entire history of the stock price, the equilibrium price process must follow a diffusion as assumed in (7) as long as the volatility of return depends only on the current stock price. This observation is useful, since empirically it is very dificult to estimate the drift term, and yet itis fairly easy to estimate the diffusion term by using finely sampled observations. If one can empirically determine that the diffusion term depends only on the current price and time, then one can claim that stock price must follow a diffusion process. To demonstrate our claim, we recall the first-order equilibrium condition Us) = TE", where £ is now defined similarly as in (3), except that u(S(2), 1) is replaced by u(w, ). Thus, a uST)) ‘Recent audios have suggested hat her economic variables way belp predic dhe unre revurn 0. We saw in Section 2 that there is no time: homogeneous diffusion process that is consistent with an equilibrium with this utility function. Since U"(S) = S-' + $-%, we find a oor 1 2p- el wal. According to Lemma 2, we have p(In 8 — to T— 1) T~ ans tor) FA) Clearly, S is not a time-homogeneous diffusion process. If we let T g0 to infinity, then 4 converges to @ if a <= 1 and to ota if a > 1 ‘Thus, ifthe lifetime horizon is sufficiently long, the equilibrium price will behave approximately like a geometric Brownian motion. Note that when 0 1, S*/Q ~ a) dominates In 5, and therefore the equilibeium price is determined by S-*/ = The following proposition establishes an important property of the expected instantaneous return function when the utility function of the representative investor exhibits increasing or decreasing relative risk aversion. We need to impose some regularity conditions for this proposition. Condition R 1. There exists a constant K > Osuch that for all x, y > Oand te (0. t), Lame, D — eG, OLS Kix yh, Law, D1 = KO +), and there exist constants L > 0. and m > 0 such that for all x > 0 and t© [0,1 a e | Scouse | + [5 OuG 0] = £0 + =) 6122. xU"()|UCx) is twice continuously differentiable for x > Oand its derivatives satisfy a polynomial growth condition, where U ts the utility function for the representative investor. Proposition 2. Suppose Condition R is satisfied. Let u be the equilib rium expected instantaneous return function such that it satisfies the conditions in Proposition 1 with a constant ¢. Then, for every t€ /0, T), us, 0 is increasing (decreasing) in x ifand only if the relative risk aversion —xU" (x)/U"(x) és increasing (decreasing) in x. Proof: The necessary part ofthis proposition is obvious. We only prove the sufficient part. First, we note that given the regularity conditions imposed on w and the fact that g satisfies the necessary conditions in Proposition 1, the Feyman-Kac representation implies that gis @ martingale under P (see, for example, Karatzas and Shreve (1988, Theorem 5.7.6)}. Thus, we can express as HC, ) = Blu S(7), 7)1S(0) = 3 Now, let us fix tand x and denote the price process on [1, T] with S(1) = x by 17); ¥ € [f, TI). Applying Theorem 5.5 of Friedman (41975) of Theorem 1, Chapter 2, of Gilman and Skorohod (1972), wwe claim that $*is differentiable with respect to x, the initial data S*. Furthermore, let D* denote the derivative of $* with respect to x defined on [1, 7}. Then D* satishes AD*(x) = (ul SCH), 2) + S*()u( $C), 1) DAG) dr + oDM(r) dwn), with D*@ = 1. Since |a(S, 1) + Suy(S, | is continuous and bounded above by a polynomial function, ff [w($*(), 1) + S*@)us(S@), 1] dr < @, Pas, It then follows that Dis) = ool f’ (us D+ HOUSED, D — 3) ae + a(w(s) = won} 0. Following again Theorem 5.5 of Friedman (1975), we obtain Hs(5 9 = Eug(S(D), DOTY) on 2( 2D 7 Ls vO) Yn oo] Since D*(T) > 0, we conclude that u,(S, £) is increasing (decreasing) in Sfor t€ 0, 7] ifthe relative-risk aversion is increasing (decreasing) in terminal wealth. . 613The Review of Financial Studies» 6m 3 1993 Now, consider the dynamics for the log price, dn S() = (a(S), D ~ io") dt + 0 dw(0) ‘When 4 is decreasing in the level of the stock price, the log:price process always exhibits “mean reversion!” in the sense that the return of the stock price moves in the opposite direction to the level of the stock price, Proposition 2 demonstrates that mean reversion is nat: urally associated with preferences that exhibit decreasing relative risk aversion, when the Volatility of stock return is constant, Similarly, “mean aversion” processes are naturally associated with preferences that exhibit increasing relative risk aversion, 4, Concluding Remarks We have provided an approach to characterize equilibrium asset price processes within the family of diffusion processes in a specialized pure exchange economy. In our economy, we assume that the secu rities markets are dynamically complete, all investors have a state independent utility function and receive no exogenous income, and all investors consume at some fixed future date. We derive our char acterization by exploiting the equilibrium condition that the repre: sentative iavestor optimally holds the total supply of risky assets and therefore follows a path-independent strategy. Consequently, our equilibrium conditions include, but are stronger than, those derived in the intertemporal capital asset pricing models. ‘Market completeness has played an important role in our analysis, Ie allows us to formulate the model by using a representative investor framework, It also permits us to determine the unique Arrow-Debrew state prices, It would therefore be interesting to see how ourapproach can be generalized to an incomplete markets setting. “The assumptions that investors receive no exogenous income and that their preferences can be represented by a von Neumana~Mor senstern, state-independent utility function are also crucial ones. For example, if we had allowed state-dependent utility functions o ran: dom exogenous income, then any arbitrage-free asset price process could be supported by an equilibrium. Given that there is a growing interest in non-time additive utility functions, such as utility funetions that exhibit habit formation, it would be interesting to extend our analysis for such utility functions. Appendix Proof of Theorem 1. We prove the sulliciency of Theorem 1. To do 80, we transform the representative investor's dynamic consumption eaEqui Price Procenes and investment problem into a static sup EUGW(T)), HECTW(T) eS We, can) In other words, the dynamic budget constraint in (4) is replaced by a static budget constraint [see Cox and Huang (1989)]. The first-order condition for the static problem is that there exists a scalar \ > 0 so that ty maximization problem: NTE“, if WET) > 0, = MCT)e"", if W(T) =. Since in equilibrium the representative investor holds one unit of the stock and consumes the final value of the stock at the final date, we have W(T) = S(T) in equilibrium. Because we have assumed that S(T) > 0,43., the first-order condition should always hold in equal ‘As we discussed earlier, the utility function that supports this equi librium satisfies us) _ [LaDy ws) coo( S x “) where $,= S(0). Define g(S, ) = ~ J&, f(x, O/x dx: tis now sufficient to show that g(S(7), 7) = In (7) for some constant ¢. To do so, We apply It's lemma to g v'anny) as at 2 gs, = ~£(us di + 05 dw) -@-4 S78, ~ (fA 2 as) a ar ae MO) aay = (a) aera ao 2 fla -(furssian« [St aa = aing@ -(rSerrsa-p+ [ee ds) (a2) Now, define 1S, D =f + DSF + Sh H Since 1(S, 1) = (So, 2) + J§, [4 ) dxand f satisfies the PDE (7), we have 615,The Review of Financial Stuates/ v6 m 31993 0+ f (a0 1) + ole, Dots (PD + filo 0 — $9) HEP pe n.6o0 + afl oy) = 165, ~ fH? ae Substituting /(S, 1) into (A2), we get dg(S), 1) = din EW) — KS, 0 dt Integrating both sides, we find g(S(T), T) = In 7) ~ f US, de This completes our proof. . 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