Assignment Example | Topics and Well Written Essays - 1000 words - 69

Assignment Example Fed can purchase government either securities or lowers current reserve rations. In doing so, interest rates will fall and hence bringing the economy back to full employment. Suppose on observing that there is excess money supply in the economy, Fed will use open market operations to try to reduce the excess supply. Sales of government securities contract the assets accessible to lend and tend to increase the federal funds rate. Policymakers call this contractionary monetary policy or tightening. The Fed is targeting an interest rate level that would enable it achieves and controls its goal for employment. Economic growth, interest rate stability, and inflation can hit this rate target by choosing an appropriate value of money supply that will equate to money for equilibrium conditions in the capital market. The sale of government securities leads to a decrease in money supply from MS1 to MS2 in the economy. As a result, the current reserve ratio increase and hence putting an upward pressure on the Fed interest rate (Setterfield 105-116). Therefore, contracting policy results in the increase in interest rates from R1 to R2 and hence the cost of borrowing from commercial banks increases discouraging borrowing. When Fed sells government securities, it reduces money supply in the economy. The fall in money supply results in an increase in interest rates to R2. The increase in the interest rates reduces the level of aggregate demand and investment to I2 and hence a reduction in real GDP. As soon as the economy is in the recessionary gap, the Fed will implement an expansionary monetary policy to upsurge money supply in the market through three monetary policy instruments. By buying government securities and bonds, the Fed target will be to reduce the interest rate level. Moreover, it can lower the reserve rate or lessen the discount rate. The move will lead to a reduction in lending rates; hence, commercial banks will be encouraged borrowing

Empirical Asset Pricing Theory Assignment Example | Topics and Well Written Essays - 1500 words

Empirical Asset Pricing Theory - Assignment Example In other words, the paper will look at the negative covariance of SDF and excess returns. The paper will also outline the Fama-French factors. This will include entailing how these factors work, and the motives behind choosing or selecting of models. Finally, the paper will discuss how the technique used by Pastor and Stambaugh differ from the ones used by Fama-French factors. Stochastic Discount Factor Pricing Model SDF as a Factor Pricing Model According to Fama and French (25 - 30) this model helps in the formulating of n econometric analysis that is used in the pricing of assets. The methods included this model include the capital asset pricing model that was proposed by Sharpe in 1964 and other as well as the consumption based inter-temporal capital asset pricing models (CCAPM). Stochastic discount factor (SDF) uses both of the approaches that are used in asset pricing. This includes the absolute and the relative pricing of asset. The absolute pricing of asset involve the pricin g of an asset relative to the sources that expose it to the macroeconomic risks. The relative pricing of asset entails pricing assets according to how other assets are priced. The pricing equation that is used to estimate the stochastic discount factor is normally assumed. The limitations that are imposed on the behavior relating to the stochastic model are assumed to be standard. Based on the pricing equation assumptions the model, the price of n asset which is denoted as ‘t’ is calculated through discounting the value of the assets in the period of paying off. The equation for determining the price of the asset is: Pt=ET (Mt+sXt+s). The assets pay off is represented by Xt+s while the discounting factor is represented by Mt+s. the part denoted as ET represents the expectation given the information that is available at a given time t. The discounting factor represents the stochastic variable (Renault and Hansen 3-15). The assets that can be priced using this model inclu de a stock that pays a dividend of DT+1. This stock should also have a resale value and a pay off period. A treasury bill is also applicable if only it pays only one unit of goods or a good being consumed. This equates the payoff to 1. A bond whose coupon payment is constant and yet can be sold is applicable for pricing using this model. This model can also price bank deposits that pay the risk free return rate and equate the pay off period to 1+ rft. Finally the call option whose price is Pt and gives the holder of the option the right of purchasing any stock at the price exercised (Renault and Hansen 12-21). Assumptions Relating to the Form of SDF In the development of the stochastic estimator, there are four assumptions that are taken into considerations. The first assumption is that the pricing equation 2 always holds. This equation is equivalent to the law of one price. The assumption here is that all the securities that have the same pay off should bear the same price. There a re no choices of the preference. The second assumption states that the stochastic discounting factor labels Mt to be greater than zero. The same applies even to mimicking portfolio. The implication here is that no arbitrage opportunities exist. The third assumption states that the risk free rate exists. The risk free rate is measurable relative to sigma-algebra. The conditioning set that is also used in the computation of the conditioning moments generates this algebra. The existence of this rate allows for payoff space that is