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Drawing on Chs. 4 and 5 (which discuss the supply and demand for securities separately), this chapter investigates whether economics has anything helpful to say about the prices of shares and related securities by reviewing the most important ideas suggested by economic theory in this area and assessing their usefulness in the real world. In the first two sections, two fairly ancient but still popular models of equity (share) prices are examined, one of which (the steady growth model) views shares as claims to future dividends and the other (the asset model) views them as claims to the underlying net assets (corporate net worth). For the most part, these models look at the shares of individual companies in isolation, not at the market as a whole, and that is their weakness, but the asset model in particular provides important insights into aggregate equity values; as an aside to this discussion it is shown that aggregate dividends have the intriguing feature of being an approximately constant percentage of national income, which means that corporate equities offer protection (though not perfect protection) against inflation as well as participation in the real growth of the economy. The third section looks at the Capital Asset Pricing Model (CAPM) – a discovery of the 1960s that, by considering equities in relation to each other, provided important new insights into the relation between risk and return. A more recent alternative approach known as Arbitrage Pricing Theory is discussed next, and finally there is a section (an appendix) on stock indexes.

This chapter presents a systematic overview of the pricing theory for financial derivatives, which are, in some sense, connected to the extremal values of the underlying price process. It focuses on barrier options, ladders, and lookbacks, and is limited to the case of one underlying asset. Practice exercises are included.

Since the Great Recession financial macroeconomists have argued that the US government should have supported the liquidity of accumulated capital, but that standard options theory can be used to price the premium that it could/should have extracted for guaranteeing macroeconomic liquidity (the right to put unmarketable securities to the government at par in return for government debt). This chapter reads this literature politically by arguing that the macroeconomic liquidity premium is equivalent to the present value of historical justice as an out-of-the-money democratic option to wipe out the unjust effects of capital accumulation by bringing on an illiquidity event. The equation of private and public debt is central the options pricing formula itself, which creates hypothetical portfolios engineered to be equivalent to risk-free government debt in order to solve for the theoretical price of riskier components, like puts and calls. This methodology for pricing options assumes away the fact that government is not obliged to swap its debt for AAA private debt at par; but it does allow government to price the premium it could extract for obliging itself to do so. (That premium could have reached $9T in 2008.)

The consumption-based asset pricing models are elegant, but tests and applications suffer from the questionable quality of the available consumption data, and at least some of these models are unsuccessful in matching empirical facts. This motivates a search for models linking asset prices and returns to other factors than consumption. This chapter studies the so-called factor models that link the prices of the many available financial assets to a number of common observable pricing factors. The relation between state-price deflators and pricing factors is investigated. The classic CAPM and the Arbitrage Pricing Theory are reviewed. The role of mean-variance efficient returns in factor models is explored. In multi-period settings the distinction between conditional and unconditional pricing factors is emphasized. The envelope condition derived in Ch. 6 is shown to serve as a theoretical foundation for the choice of pricing factors. Finally, a brief overview of empirical studies of factor models is provided.

The theoretical mechanism by which the public attributes value to the attention of politicians to public policy topics is the subject of this chapter. Drawing on asset pricing theory from the economics of finance, we provide the theoretical means by which policy capital takes on value for voters. Central to the approach is the responsiveness of public valuations to innovations in competence factors, which impact the value of all policy priorities in different ways. Given pricing information, politicians can select and rebalance the attention they allocate in party manifestos. Once in office, parties can rebalance their policy portfolios through the Speech from the Throne. Vital to the estimation strategy we elaborate in the next chapter are levels of risk and price signal uncertainty that policy portfolios incorporate.

This chapter examines the emergence and consequences of a vernacular “science of financial investments.” While many eighteenth-century writers saw financial knowledge as devilish and destructive (centered upon the bodily and verbal skills required by street transactions), these new authors set out to build a science of investments grounded in observation and calculation. Among the main outcomes of this process are the rationalization of investor behavior and the representation of financial markets as supra-individual, quasi-natural entities, which cannot be controlled by any group. It is the latter notion which allowed for the shift to price behavior as the core actor of abstract market models. The effort to transform investment knowledge into a science is crowned by the formulation of basic views of the random walk hypothesis. The first mathematical formulation of the random walk hypothesis plays a decisive role in the development of mathematical finance (more specifically, of the options pricing theory). The main tenet of the random walk hypothesis is that securities prices move independently of each other, and that future movements do not depend on past movements. One of the most important implications of this hypothesis is that in the long run, the market cannot be controlled by any group or person.

This chapter examines the scholarly work and personal communications between Milton Friedman and George Stigler on price theory and methodology in the early years of their careers. Friedman and Stigler had different intellectual inclinations and interests. Friedman’s interests were in statistics and empirical analysis. Stigler’s were in theory and the history of theory. Their critiques of the theory of monopolistic competition, though formed separately, had common themes. These themes, relating to the purpose of economics, how one does economics, and how one evaluates the value of a particular piece of economic research, became the basis of the distinctive postwar Chicago School.

The chapter focuses sharply on liquid assets, and is the heart of the book. It distinguishes between intrinsic and extrinsic liquidity, centering on the latter. Extrinsic liquidity may break down on the spur of the moment and generate socially costly Liquidity Crunch. A substantive part of the chapter is devoted to discussing relative resilience of liquid assets, and focuses on Keynes's Price Theory of Money, the resilience of the US dollar, the weakness of bonds denominated in that currency, and of currencies of emerging-market economies. The chapter claims that recent financial crises can realistically be modeled as old-fashioned bank runs, and that assets' liquidity may be a function of policy. Special attention is paid to a phenomenon called Liquidity Deflation, which helps to rationalize Liquidity Trap as a consequence of loss of money liquidity rather than on the conventional explanation based on the infinite interest elasticity of money demand.

The chapter explores two significant challenges faced by central banks in LFDCs: fiscal dominance and external shocks. Monetary policy can be dominated by governments that rely on seigniorage generated by the central bank or impose other constraints to facilitate the financing of persistent deficits. The chapter discusses and illustrates for several countries the concept of seigniorage, examines the mechanisms of fiscal dominance, and assesses its consequences. External oil and food price shocks also raise several monetary policy challenges. Using a theoretical approach, the chapter explores the trade-off between price and output stabilization that the central bank faces after a commodity price hike. The analysis takes into account whether the country is a net exporter or a net importer and whether it is on fixed or on flexible exchange rates. It also discusses coordination issues between monetary and fiscal policies, in particular when windfall gains accrue to the government.

When Friedman came to the University of Chicago as a graduate student in 1932, Jacob Viner was perhaps the foremost economist on the faculty. Friedman took Viner’s famous price theory class, which gave him a deep appreciation for economic theory as applied to real-world problems. Friedman himself carried on the Marshallian price theory tradition that Viner had established and taught the course when he joined the Chicago faculty in 1946. While Friedman always acknowledged that Viner deeply shaped his approach to economics, the two later disagreed on monetary policy rules, exchange rate policy, and the role of government in the economy.

In the 1970s, McCloskey trained a generation of graduate students in the way of thinking that has come to be known as "Chicago price theory". McCloskey's mastery of the subject, extraordinary teaching skills and legendary generosity combined to create an intellectual legacy that has profoundly affected the way economics is taught and understood at institutions all over the world. This essay is a tribute to that legacy and its creator.

The CAPM and factor models in general are explained. Factors can be replaced by the returns or excess returns that are maximally correlated (the projections of the factors). A factor model is equivalent to an affine representation of an SDF and to spanning a return on the mean‐variance frontier. The use of alphas for performance evaluation is explained. Statistical factor models are defined as models in which factors explain the covariance matrix of returns. A proof is given of the Arbitrage Pricing Theory, which states that statistical factors are approximate pricing factors. The CAPM and the Fama‐French‐Carhart model are evaluated relative to portfolios based on sorts on size, book‐to‐market, and momentum.

This chapter contains personal memories of Milton Friedman’s teaching as part of the Chicago PhD program in the academic year 1960 and 1961, supplemented by textbook assignments and some of his writings, notably in price theory, consumption theory, and monetary economics. As a teacher, Friedman’s classes were clinical experiences, like making the hospital rounds with a brilliant doctor. The emphasis was on teaching students how to analyze economic behavior, to understand how policies or other forces alter behavior. Friedman’s goal was not simply to replace the authority his students were questioning with his own authority—though that would have been easy for him to do—but to equip them to identify the needed economics and apply it correctly themselves.