Realized returns have three components: the expected return, the return due to Cash flow news and the return due to the discount rate news. To better understand these components, we start the analysis by assuming a single-period economy, starting at Date 0 and ending at Date 1. For simplicity, we refer to Date 0 as today and Date 1 as tomorrow. The analysis can easily be extended to different periods, but the simplified valuation framework considered here is sufficient for deriving the standard asset pricing results.
A representative 1 investor living in our simplified economy is faced with the problem of choosing how much of his or her wealth, he or she will allocate for consumption today and how much he or she will save and allocate for consumption tomorrow. The allocation of consumption between today and tomorrow facilitated by the existence of an asset market. An asset is a financial contract that requires a cash outlay today from the buyer, and that provides a payoff to the buyer in the future. The payoff provided by the asset can then be used for consumption—that is, for buying some units of the consumption good in the future (Markowitz, 1952).
The investor makes his or her investment decisions today, at Date 0, and receives a payoff from his or her investments tomorrow, at Date 1. The fact that the investment is made today, and the payoff is obtained in the future reflects the time dimension of asset pricing. However, to generate some relevant predictions for asset prices, we must also incorporate uncertainty about the future into the analysis. This can easily be done by assuming that there are different states of nature that can occur tomorrow. It also assumed that the payoffs from the assets are state contingent in the sense that the payoff for a given asset might vary over the possible states of nature, but once we know what state will occur, we also know with certainty the payoff that the asset will provide. We also assume that we can assign probabilities to these mutually exclusive states of nature so that these probabilities for the different states sum to 1. Risk in this framework then captured by the fact that the investor, making his or her investment decisions today, will not know with certainty the state of nature and, consequently, the associated payoffs from his or her assets that realized tomorrow.
Systematic and Unsystematic Risk
We can understand this prediction by recalling that the stochastic discount factor is a function of the investor's marginal utilities in the different states of nature. An investor cares about how the asset behaves in good and bad states of the economy, where the marginal utility of the investor reflects the state of the economy. An asset with a payoff variation that is wholly unconnected to the variation in marginal utilities behaves like a risk-free asset: Its payoff pattern is not directly connected to the well-being of the investor in ...