University of Geneva

Consumption CAPM
& Equilibrium

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Motivation
Principle of no-arbitrage gives first idea about asset prices.
Strength: Price redundant assets relative to fundamental assets.
Weakness: Tells us nothing about how to price fundamental assets.
Have shown prices of fundamental assets determined by state prices, ψ.
But what are the state prices?

⇒ Introduce Consumption CAPM to price any asset & interpret ψ.

Basic pricing equation of C-CAPM doesn’t completely determine prices.

Interesting idea is that prices are determined by trade.
But trades in turn depend on prices: chicken & egg problem.

⇒ Introduce concept of competitive equilibrium,

which captures interdependence of decisions and prices.
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Consumption-based Capital Asset Pricing Model

Investors decide how much to save and how much to consume.

Prices arise from this trade-off

(more formally, pricing equation arises from F.O.C. of this decision)

Marginal utility loss of consuming less today equals

marginal utility gain of consuming more of asset’s payoff tomorrow.

Price doesn’t satisfy this relation ⇒ agent should buy more/less of asset.

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Model Setup
There are two dates, t and t + 1. Agent has original endowment et
and et+1 in the two dates. Can consume or use it to buy asset.
Consumption: ct is consumption today, and
 
ct+1,1
ct+1 =  ...  is consumption tomorrow.
 

ct+1,m
Agent’s preferences over consumption “bundles” represented by utility
U (ct , ct+1 ) = u (ct ) + Et [βu (ct+1 )] .
The subjective discount factor β captures impatience.
Curvature of vNM utility u captures:
Aversion to risk - agent prefers consumption that is steady across states.
Aversion to inter-temporal substitution - agent prefers consumption
that is steady over time.
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Basic Pricing Equation

Assume there is only 1 asset, with payoff bt+1 . What is its price, St ?
We will express St in terms of the agent’s optimal consumption.
The agent chooses θ, the # of units of asset he buys at time t to solve
max u (ct ) + Et [βu (ct+1 )]
s.t. ct = et − St θ
ct+1 = et+1 + bt+1 θ
∂
Substituting constraints into the objective, and setting ∂θ equal to 0:
 
∂ ∂
u (et − St θ) + Et {βu (et+1 + bt+1 θ)} = 0 ⇒
∂θ ∂θ
−St u0 (et − St θ) + Et β bt+1 u0 (et+1 + bt+1 θ) = 0
 

so
St u0 (ct ) = Et β u0 (ct+1 ) bt+1 .
 

LHS = loss in utility if agent buys another unit of the asset

RHS = increase in (discounted, expected) utility from extra unit.
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Stochastic Discount Factor

We define the stochastic discount factor (SDF)
u0 (ct+1 )
mt+1 = β .
u0 (ct )
Then the basic pricing equation
 0 can be written as
u (ct+1 )
St = Et β bt+1 = Et [mt+1 bt+1 ]
u0 (ct )
= covt (mt+1 , bt+1 ) + Et [bt+1 ] Et [mt+1 ] .
Price of asset is high when asset’s payoff is high in states in which SDF is
high, i.e. marginal utility is high, i.e. consumption is low.
SDF generalizes idea of discount factor:
If asset is riskless, its price is Stf = bft+1 /Rf .
If asset is risky, its price is Sti = bit+1 /Ri , where Ri > Rf .
Other names for the stochastic discount factor:
a) Marginal Rate of Substitution b) Pricing kernel
c) Change of measure d) State-price density
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Relation between SDF and State Prices

We have seen that “no arbitrage” ⇔ S = A0 ψ for ψ  0.
E.g., for asset j we have
Sj = (A·j )0 ψ
= A1j ψ1 + A2j ψ2 + . . . + Amj ψm

Multiply and divide each state price by the corresponding true probability:
     
ψ1 ψ2 ψm
Sj = A1j p1 + A2j p2 + . . . + Amj pm
p1 p2 pm
 
ψi
= E Aij
pi
This is the same pricing equation we derived earlier, if we set
ψi
mi = .
pi
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Competitive Equilibrium
A way of modelling the interaction between many agents in the economy.
Simple framework:
There are only two investors.
There is no 1st period consumption.
There are only two states.
The only traded securities are the two Arrow-Debreu securities.

Definition
A Competitive Equilibrium is a set of prices and portfolio allocations
such that all agents maximize their utility subject to their budget
constraints and all markets clear (i.e. aggregate demand for each asset
equals aggregate supply).

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Competitive Equilibrium - Edgeworth Box

Two investors, A and B, each endowed with some A-D securities.
Edgeworth box is diagram representing each investor’s A-D securities.
Width of box is total amount of A-D of state 1, and
Height of box is total amount of A-D of state 2.
Two opposite corners serve as “origins” for the two investors.
⇒ All possible allocations of the securities between the two people can
be represented as a point in the box.
B's A-D securities for state 1 B

B's A-D securities for State 2

A: A-D1 = 2, A-D2 = 7
B: A-D 1 = 18, A-D2 = 3
A's A-D securities for State 2

A: A-D1 = 15, A-D2 = 6

B: A-D 1 = 5, A-D2 = 4

A: A-D1 = 10, A-D2 = 2

B: A-D 1 = 10, A-D2 = 8
A A's A-D securities for State 1

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Indifference Curves
Let X be a choice set whose elements are bundles of different goods. An
indifference curve represents the set of bundles among which an agent is
indifferent.

Ib = {x ∈ X|b ∼ x}
Bundles above and to the right of b are more preferred.
Indifference curves are negatively-sloped and convex to the origin.
Indifference curves cannot intersect.
Slope of indifference curve: Marginal Rate of Substitution= dx
dx1 .
2

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Budget Constraint
A budget constraint is a constraint on how much money an agent can
spend on goods. Let M ≥ 0 be the amount of money available,
{x1 , x2 , . . . , xN } the quantities of goods purchased and {p , p2 , . . . , pN }
P1N
the corresponding prices. The budget constraint is then: i=1 pi xi ≤ M .

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Utility Maximization
Agent’s problem: Find the point on the highest indifference curve that is
in the budget set.
maximize u (x1 , x2 )
x1 ,x2

subject to p1 x1 + p2 x2 ≤ M

Indifference curve must be tangent to the budget line, so M RS = − pp12 .

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Constrained Optimization and Lagrange Multiplier

Constrained optimization:

max f (x) subject to g (x) = 0

⇔ Unconstrained optimization with a Lagrange multiplier λ:

max {f (x) − λg (x)}

L := f (x) − λg (x) is called the ‘Lagrangian’ function

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Intuition of Lagrange Multiplier

Consider simple version with two decision variables and one constraint:

max f (x1 , x2 )
x1 ,x2

subject to g (x1 , x2 ) = 0
Think of f as utility function, and g as budget constraint.

Instead of forcing the agent to respect constraint, allow to choose

x1 , x2 freely, but impose penalty λ per unit violation of constraint.

⇒ Payoff net of penalty is the Lagrangian

L (x1 , x2 , λ) = f (x1 , x2 ) − λg (x1 , x2 )

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Intuition of Lagrange Multiplier

So agent maximizes (unconstrained), taking λ as given. F.O.C.:
∂f (x∗ ) ∗
∂L
∂x1 = ∂f
∂x1
∂g
− λ ∂x1
=0⇒ ∂x1 = λ ∂g(x
∂x1
)

∂f (x∗ ) ∗
∂L
∂x2 = ∂f
∂x2
∂g
− λ ∂x2
=0⇒ ∂x2 = λ ∂g(x
∂x2
)

There is no guarantee that solutions of this system, x∗ will be optimal

solutions of the constrained problem.

But if we pick the correct penalty, λ∗ , the agent will respect the
constraint, even if he doesn’t have to.

Thus, λ∗ must be such that the constraint holds, i.e., we also need
∂L
∂λ = g (x1 , x2 ) = 0.
So we have 3 equations to be solved for x1 , x2 , λ.
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Intuition of Lagrange Multiplier

 
∂f
Gradient 5f or Df is vector of partials ∂x , ∂f
1 ∂x2
It is the vector pointing in the direction of steepest ascent along graph

Lagrange Theorem says Df (x∗ ) = λDg (x∗ ), i.e., parallel gradients

So if we relax constraint (move to “higher” level set of g), λ tells us how

much f will increase. This is how much a rational agent would be willing to
pay for an additional unit of the resource
⇒ λ is “shadow price”

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Utility Maximization (cont’d)

Agent’s problem: max u (x1 , x2 )
s.t. p1 x1 + p2 x2 ≤ M
The budget constraint is binding (i.e. holds with equality).
The Lagrangian is
L = u (x1 , x2 ) + λ (M − p1 x1 − p2 x2 ) .
Taking F.O.C. w.r.t. x1 , x2 and λ we find
∂L ∂u
=0 ⇔ − λp1 = 0 (1)
∂x1 ∂x1
∂L ∂u
=0 ⇔ − λp2 = 0 (2)
∂x2 ∂x2
∂L
= 0 ⇔ M − p 1 x1 − p 2 x2 = 0 (3)
∂λ
∂u ∂u ∂u
∂x1 ∂x2 ∂x1 p1
(1) and (2) imply that p1 =λ= p2 or ∂u = p2 .
∂x2
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Competitive Equilibrium - Edgeworth Box

Can draw indifference curves among allocations for each individual.
Indifference curves are asset combinations of equal value.
Points where indifference curves are tangent are such that you can’t
make one better off without making the other worse off (Pareto set).
Equilibria are points in the Pareto set such that indifference curves are
tangent to the budget constraint.
Any equilibrium lies on the part of the Pareto set at which both
agents are better off than at their initial endowments (contract curve).
B's A-D securities for state 1 B

B's A-D securities for State 2

A's A-D securities for State 2

A A's A-D securities for State 1

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Equilibrium - Applets on the Web

http://www.econlab.arizona.edu/software/edgeworth/

http://www.sscnet.ucla.edu/ssc/labs/cameron/e1f98/imapedge.html

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Example
Assume ∃ 2 investors (A, B), 2 states (1, 2). Initial endowments are:
Investor A has 10 units of the Arrow-Debreu security for state 1, and
20 units for the Arrow-Debreu security for state 2.
Investor B has 15 units and 15 units, respectively.
Preferences are as follows:
For investor A we know that u cA A A 0.5 cA 0.5 .




1 , c2 = c1 2
For investor B we know that u cB B B 0.2 cB 0.8 .




1 , c2 = c1 2
a. Draw an Edgeworth box, indicating the initial allocation.
b. Draw the indifference curves.
c. Draw the set of Pareto Optimal allocations.
d. Indicate the contract curve (i.e. set of Pareto Optimal allocations at
which both individuals are better off than at their initial endowments)
e. On a new Edgeworth box, indicate the equilibrium.
f. Calculate the budget constraint for each individual, given prices.
g. Calculate the optimal consumption for each individual, given prices.
h. Calculate the equilibrium prices and the equilibrium allocation.
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Solution (a), (b), (c), (d), (e)

Indifferences A B
Indifferences B B 35
Indifference A
35

Pareto Optimal Budget

Set
I
I 20
20
E

Contract Curve
Indifference B
A 10 25 A 10 25

I indicates the initial allocation,

A and B the origin for investor A and B, respectively, and
E indicates the equilibrium allocation.
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Solution (f), (g)

f. Given endowments eA A
1 and e2 and prices p1 and p2 , the budget
constraint for investor A is derived by equating the initial wealth of
investor A at these prices with the value of the portfolio he buys.
So if he buys xA A
1 units of A-D security for state 1 and x2 units of
A-D security for state 2, then the budget constraint is
p1 eA A A A
1 + p2 e2 = p1 x1 + p2 x2 .

Similarly, for agent B we have

p1 eB B B B
1 + p2 e2 = p1 x1 + p2 x2 .

g. Investor A maximizes his utility subject to his budget constraint:

max u xA A


1 , x2
xA A
1 ,x2

s.t. p1 eA A A A
1 + p 2 e 2 = p 1 x1 + p 2 x2 ,

where we use cA A A A
1 = x1 and c2 = x2 , since he consumes all payoffs.
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Solution (g) - continued

g. Lagrangian is L = u xA A A A A A



1 , x2 + λ p1 e1 + p2 e2 − p1 x1 − p2 x2 .
∂L A A = λp


First Order Conditions are: ∂x A = 0 ⇔ u1 x1 , x2 1
1
∂L
= 0 ⇔ u2 xA A


∂xA 1 , x2 = λp2 .
2

Combine these and substitute for u1 xA A A −0.5 xA 0.5 :

1 , x2 = 0.5 x1 2
1
−0.5 A
0.5 1
0.5 A
−0.5
· 0.5 xA
1 x2 = · 0.5 xA
1 x2 .
p1 p2
p1 A
Manipulate this, to find xA
2 = p2 x1 , and impose budget constraint:
1 A 1 p2 A 1 p1 A 1 A
xA
1 = e1 + e xA
2 = e + e2 .
2 2 p1 2 2 p2 1 2
Working similarly for investor B, we find that
1 B 1 p2 B 4 p1 B 4 B
xB
1 = e1 + e xB
2 = e + e2 .
5 5 p1 2 5 p2 1 5
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Solution (h)
h. We impose the market clearing conditions, i.e.,

xA B
1 + x1 = eA B
1 + e1
xA B
2 + x2 = eA B
2 + e2 ,

by substituting optimal allocations we found above in these, to get:

1 A
p2 e + 4 eB
= 21 1A 51 1B .
p1 2 e2 + 5 e2
p2 17
Substituting for the initial endowments, we have p1 = 13 .
Substituting prices back in allocations, the equilibrium allocations are:
235 235
xA
1 = xA
2 =
13 17
90 360
xB
1 = xB
2 = .
13 17
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