Sharpe's State-Preference Approach and Beyond

Abstract

In his recent book, Nobel Prize-winner William Sharpe notes that, in contrast to MBA curricula focusing on the capital asset pricing model (CAPM), “[i]f you were to attend a Ph.D. finance class...you would learn about no-arbitrage pricing, state claim prices, complete markets, spanning, asset pricing kernels, stochastic discount factors, and risk-neutral probabilities.” Sharpe's illustration of these concepts in a state-preference framework raises important questions for practitioners. Has the role of CAPM beta changed? Should investors still expect asset returns to be linear in beta as in the CAPM? What are the implications for other asset pricing models, such as arbitrage pricing theory (APT)? How does the state-preference framework clarify issues such as anomalies found by CAPM researchers, the peso problem, nonstationary volatility, tail risk, correlations going to unity in crises, smiles in option pricing, and the equity premium puzzle? The author provides an overview of Sharpe's work and addresses these practitioner questions.