This article was downloaded by: [INASP - Pakistan (PERI)]

On: 24 September 2013, At: 03:58

Publisher: Routledge
Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office:
Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK
The European Journal of Finance
Publication details, including instructions for authors and subscription
information:
http://www.tandfonline.com/loi/rejf20
The Intertemporal Capital Asset Pricing
Model with returns that follow Poisson
jumpdiffusion processes
Eric Bentzen
a
& Peter Sellin
b
a
Institute of Operations Management, Copenhagen Business School,
Denmark
b
Research Department, Sveriges Riksbank, Stockholm, Sweden
Published online: 23 Mar 2012.
To cite this article: Eric Bentzen & Peter Sellin (2003) The Intertemporal Capital Asset Pricing Model with
returns that follow Poisson jumpdiffusion processes, The European Journal of Finance, 9:2, 105-124, DOI:
10.1080/13518470110099704
To link to this article: http://dx.doi.org/10.1080/13518470110099704
PLEASE SCROLL DOWN FOR ARTICLE
Taylor & Francis makes every effort to ensure the accuracy of all the information (the Content)
contained in the publications on our platform. However, Taylor & Francis, our agents, and our
licensors make no representations or warranties whatsoever as to the accuracy, completeness,
or suitability for any purpose of the Content. Any opinions and views expressed in this
publication are the opinions and views of the authors, and are not the views of or endorsed
by Taylor & Francis. The accuracy of the Content should not be relied upon and should be
independently verified with primary sources of information. Taylor and Francis shall not be liable
for any losses, actions, claims, proceedings, demands, costs, expenses, damages, and other
liabilities whatsoever or howsoever caused arising directly or indirectly in connection with, in
relation to or arising out of the use of the Content.
This article may be used for research, teaching, and private study purposes. Any substantial
or systematic reproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or
distribution in any form to anyone is expressly forbidden. Terms & Conditions of access and use
can be found at http://www.tandfonline.com/page/terms-and-conditions
The European Journal of Finance 9, 105-124 (2003)
1
1 Routledge
\. r.,lor' -"Group
The Intertemporal Capital Asset Pricing
Model with returns that follow Poisson
jump-diffusion processes
ERIC BENTZEN1 and PETER SELLlN
2
'Institute of Operations Management, Copenhagen Business School, Denmark
2Research Department, Sveriges Riksbank, Stockholm, Sweden
Capital market equilibrium Is derived In a model where asset returns follow a mixed
Poisson jump-dlffuslon process. In the resulting modified Capital Asset Pricing Model
(CAPM) expected returns are still linear In beta, but In addition premia have to be paid
to compensate the Investor for taking on jump risk. When jump risk Is dlverslfiable In the
market portfollo the model Is reduced to the standard CAPM. Jumps are found to be
prevalent In the dally returns of the market Indices In the 18 countries Investigated. A
continuous return process does not give an adequate description of the market returns
In any of the countries Investigated.
Keywords: asset pricing, CAPM, )ump-diffuslon, Poisson process
1. INTRODUCTION
Amodel of the dynamics of stock prices that seems to be gaining In popularity
Is the jump-dlffuslon (or mixed Polsson-Gausslan) process. The reason can be
ascribed partly to its realism in modelling price changes as being generated by
the arrival of two types of Information. The first type Is the usual flow of news
that gives rise to frequent and relatively small price changes, while the second
type is the rare news event that causes the price of an asset to jump.
Nimalendran (1994) suggested using the jump-dlffuslon model to conduct
'event studies'. Kille et at. (1999) use the methodology to study the effects of the
1994 Mexican crisis on US bank stock returns. Fisher (1999) investigates the ex
post Jump probabilities around the crash of 1987. He finds that the most likely
Jump dates prior to the crash are connected to a disproportionate amount of
news relating to trade Imbalances, level of the dollar, and financing of US debt.
A case can also be made for the jump-diffuslon model on purely statistical
grounds. Including jumps In the price process leads to leptokurtosls In the
distribution of returns of the magnitude that are typically observed In actual
financial time series. Other alternative models do not succeed In matching the
empirical distribution of returns to the same extent (see Akgiray and Booth
(1987) for a comparison with a mixture of normal distribution).
Early empirical evidence of Jumps In Individual stock returns were found by
Press (1967), Oldfield et al. (1977), Ball and Torous (1983, 1985) and Akgiray and
The European Journal of Finance
lSSN 1351-847X prlnt/lSSN 1466-4364 online 2003 Taylor & Francis Ltd
http://www.tandf.co.uk/joumals
DOl: 10.1080/13518470110099704
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

106 E. Bentzen and P. Sellin
Booth (1986, 1987). In a portfolio these jumps could of course
wash out, which would Imply that they would not have to be priced. Jarrow and
Rosenfeld (1984) test for the existence of jump risk In a number of US market
Indices. They find evidence of jumps In dally returns, but not In weekly returns.
Jorion (1988) finds evidence of jumps In the weekly returns on the CRSP value-
weighted Index, even after having taken account of ARCH effects. Amore recent
study of Jumps and ARCH effects Is Brorsen and Yang (1994). Kim et al. (1994)
test for the existence of a common jump component In a multivariate setting.
They find that the component stocks of the Major Market Index (MMI) contain
a common jump component. Feng and Smith (1997) find that trading profits can
be generated by employing technical analysis when returns are modelled as a
pure diffusion process. However, If jumps (and time-varying risk premia) are
Included In the model the profit opportunities Virtually disappear, giving addi-
tional support for Including jump risk In asset pricing models.
It Is In the option pricing literature that Interest In considering different
stochastic processes for asset prices (of the underlying) has been the greatest,
starting with the classical papers by Cox and Ross (1976) and Merton (1976).
The valuation of options becomes more difficult when prices follow processes
that Include jumps because It will no longer be possible to form a risk-free
portfolio, as in the Black-Scholes approach to options pricing. The llterature on
options pricing with an underlying jump-diffuslon process has therefore been
preoccupied with finding ways around this problem. Merton (1976) assumes
that Jump risk Is unsystematic, I.e. uncorrelated with the return on the market
portofolio, and therefore is not priced. Unfortunately Merton's model does not
generate option prices that are much different from Black-Scholes (Ball and
Torous, 1985). Models where jump risk Is systematic seem to be required In
order to Improve upon Black-Scholes option prices (see, for example, Bates
(1991) and Kim et al. (1994)).
Some recent papers that price options on an underlying jump-dlffuslon
process Includes Scott (1991), Trautmann and Belnert (1999), Lelsen (1999),
Bates (2000), and Kou (2000). Scott (1991) considers a jump-dlffuslon model
with stochastic volatllity and Interest rates. Trautmann and Belnert (1999) apply
Bates' (1991) equlllbrium option valuation model with systematic jump risk to
price German options. L1esen (1999) uses a randomized trinomial model, where
a Poisson process Is the driving process, to price barrier options. Bates (2000)
uses option prices to test whether the underlying Is better modelled as a
stochastic volatlllty model or a stochastic volatlllty/Jump-diffusion model. He
finds that the model Including jumps leads to more plausible parameter
estimates. Kou (2000) derives option prices In a model where the underlying Is
a jump-dlffusion with (the logarithm of) the Jump amplitudes drawn from a
double exponential distribution.
The empirical evidence suggests that Jump risk should be considered when
constructing an asset prlclng model. Ho et al. (1996) extend the continuous-time
APT framework, developed In Chamberlain (1988), by considering jump risk
and stochastic volatllity. They make a direct assumption about the form of the
stochastic discount factor, which Includes Jump risk. Jarrow and Rosenfeld
(1984) give sufficient conditions for the ICAPM, developed In Merton (1973), to
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

The lCAPM with Poisson jump-diffusion returns 107
(1)
hold for asset prices that have discontinuous sample paths. The sufficient
condition is that jump risk be diversifiable in the market portfolio. However,
they do not derive the capital market equilibrium for the case when jump risk is
not dlversifiable. This will be the purpose of the present paper. The strategy will
be to add enough restrictions to the model to be able to obtain an explicit
solution. We have not found any studies of the existence of Jumps in non-US
stock returns, except for Germany (Belnert and Trautmann, 1991), so we also
examine if there are Jumps In the market indices of 18 countries, as well as in a
world stock market Index.
The plan of the paper Is as follows. In the next section the equlllbrium pricing
relationships are derived for our Intertemporal Jump-risk Capital Asset Pricing
Model (JACPM). Section 3 tests the hypothesis that there Is undlversifiable jump
risk In wel1-diverslfied portfolios. Section 4 concludes. Appendixes A-{:, contains
mathematical derivations of results presented In the main text.
2. ASSET PRICING WITH JUMP RISK
We consider an economy of the type developed In Merton (1973) and modified
by Jarrow and Rosenfeld (1984). It Is a pure exchange economy with one good,
which serves as numeraire. The underlying assumptions are:
1. There are n risky assets and one risk-free asset. All assets are marketable
and perfectly divisible. There are no taxes, transactions costs, or restric-
tions on short sales.
2. Investors take prices as given.
3. Trading takes place continuously In time at equlllbrium prices.
4. There Is a risk-free rate of Interest, r, for borrowing and lending.
5. Investors have homogenous expectations about asset prices, which
satisfy the stochastic processes
dP
I
_
PI - lL,dt + u,dZ
I
+ f,dY - ~ e t i = I, 2, ..., n
where PI Is the price of asset i, ILl represents the Instantaneous expected
rate of return (InclUding the Jump), Zt Is a Wiener process, u
t
Is the
Instantaneous standard deviation of the rate of return conditional on a
Jump In prices not occurring, Y Is a Poisson process with parameter A, 1
Is the stochastic Jump amplitude with expected value equal to e
t
; and Zi' Y,
and 1 are assumed to be Independent. The last two terms In (1) together
represent the unexpected rate of return connected with the rare event.
6. Investors maximize their von Neumann-Morgenstern expected utility of
llfetlme consumption functions,
E, fOU(C(s), s)ds
(2)
where E, Is the conditional expectations operator given the Information
available at time t and C(s) Is the rate of consumption. Investors have
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

108
E. Bentzen and P. Sellin
Instantaneous utlllty functions that exhibit Constant Relative Risk Aversion
(CRRA),
ct-y - 1
U(C(f), f) = 1 exp(- pf), y > 0
-'Y
(3)
where y Is the Arrow-Pratt measure of relative risk aversion and p Is the
utility rate of time preference.
7. The jump amplitudes are nonstochastlc, f
j
& e
l
, i = 1, 2, .., n.
8. All Investors have the same relative risk aversion, y.
Since we are considering a multivariate model, the following matrix notation
wlll be useful:
w = (n X 1) vector of portfolio shares (wT Is the transpose of w);
v = (n x 1) vector of excess rate of return, I.e. = ILl - r for asset i;
e = (n x 1) vector of jump amplitudes;
n = (n X n) covariance matrix of (diffusion part of) returns.
Assumptions 1-4 are standard. In assumption 5, In addition to the diffusion
component, we let the returns be affected by a rare event that can cause the
prices to jump. The probability of a Jump caused by the event In the time
Interval dt Is Adt, where A Is a contant. When the event occurs, there Is an
Instantaneous jump In the return on asset I of size fl' For a homogeneous
Poisson counting process with Intensity A the Interarrlval times, I.e. the time
Interval between two successive events, are Independently and Identically
distributed. This may not be totally realistic for some events. For example, we
would expect the probablllty of a devaluation to be smaller Just after a
devaluation has occurred. However, we can look at the Jump process as a
generic rare event, In which case homogeneity wlll be less of a problem; I.e. one
type of rare event, which Is Independent of the first event having taken place.
For example, a devaluation could be followed by a strike In the steel Industry.
Other examples of the type of rare events we have In mind are stricter environ-
mental legislation, raised energy taxes, Inventions, a defaulting bank, or some
other news that typically wilt affect more than one company.
The specification In assumption 5 Is slightly different from the one adopted by
Jarrow and Rosenfeld (1984), which originated In Press (1967). They let each
price process have Its own Independent Jump component. We have chosen to
look at a rare event as something that affects more than one stock although
each stock may be affected In a different way. Assumption 6 on preferences Is
more restrictive than In Jarrow and Rosenfeld's model. They merely assume a
twice differentiable, strictly Increasing and strictly concave Instantaneous utlllty
function. We need to make the assumption of CRRA In order to get an explicit
solution.
Under assumptions 1-6, the Investor chooses a portfolio rule, w = {w/(s)17.t,
and a consumption rule, C(s), so as to maximize (2) subject to
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

The lCAPM with Poisson jump-diffusion returns
N (dP )
dW = LW,W -F - rdt + (rW - C)dt
lsi I
109
(4)
(5)
where W is the investor's wealth. The way the risk-free asset enters into the
equation for the change of wealth over time ensures that the portfolio shares
will sum to one. (See Merton, 1990, p. 127. Adescription of the construction of
the portfolio shares Is also contained In Appendix A.) The Investor's problem Is
solved by the use of dynamic programming (see Merton, 1990, Chapter 5). A
solution is found in terms of the maximum value (or Indirect utility) function,
JOY. t) = max tE, 1-V(C(s) , S)dS}
IC,w);' t
In the empirical part of the paper (Section 3 below) we assume that , is drawn
from a lognormal distribution. But to facl1ltate the theoretical Interpretation we
use assumption 7 and consider the special case of nonstochastic Jump ampli-
tudes (the general case Is treated In AppendiX C). Assumption 8 says that
investors have the same risk aversion. Thus, Investors will differ only with
respect to their wealth and utl1lty rate of time preference, which, as we will see,
will not affect their portfolio choice.
The optimal portfolio rule is Implicitly given by
(6)
as derived In AppendiX B. This portfolio rule can be compared to the similar one
derived in Merton (1990, p. 147). However, Merton assumes that jumps can only
occur in the return on the bond, which Is then not risk-free (note also that In
Merton's notation the CRRA coefficient is 1 - 'Yand not 'Y). The portfolio rule Is
clearly nonlinear. This means that there Is no easy way of aggregating portfolios.
However, from assumption 8 It Is clear that all Investors will hold the same
portfolio In accordance with (6). Hence, all Investors wlll have to hold the
market portfolio, w
m
If we.substltute the market clearing equation W = w
m
Into
(6), we can derive the 'securlty market lines' for the Intertemporal Jump-risk
Capital Asset Pricing Model (JCAPM), as described In Appendix B. The equilib-
rium pricing relationship for asset; will be
v, - ~ = Pi(v
m
- g,,;) (7)
where P, = l m ~ Is the covariance (conditional on no jump) between asset i
and the market portfolio, divided by the variance (condltlonal on no jump) of
the market portfolio; v
m
= w ~ v Is the excess rate of return on the market
portfolio; g, = -Ae
i
((1 + em)l-y - 1] Is the risk premium for jumps in the return
on assets; = 1, 2, ..., n, m; em =w ~ e Is the Jump In the return on the market
portfolio.
Equation 7 states that the JCAPM holds for expected rates of return that have
been adJusted by the risk premia for Jump risk, ~ (i = 1, 2, ..., n, m). The risk
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

110 E. Bentzen and P. Sellin
premia may be positive or negative, since the Jump amplitudes may be negative
or positive. If Jump risk Is dlverslfiable In the market portfolio, em = 0, then e, =
o(i = I, 2, ..., n, m) and the standard ICAPM will hold, thus confirming the
result In Jarrow and Rosenfeld (1984). In the case of logarithmic utility ('Y = 1)
we also get ~ =0 (i = I, 2, ..., n, m) and the JCAPM again reduces to the
standard ICAPM.
Note that two assets with the same beta can have different expected rates of
return because of different expected Jumps In their prices. For example,
consider an economy with 'Y> 1. Arare event that has a negative effect on both
asset i and the market portfolio (e, < 0 and em < 0) wltl result In a positive risk
premium for asset i a, > 0). If the same event has a positive effect on the return
to asset j (e
J
> 0) It will result In a negative risk premium for asset j (tj < 0).
Thus, the required rate of return will be higher on asset i than on asset j even
If they have the same beta value (fJ, = Pi).
The risk premia can also be written In terms of the Indirect utility function
as
_ J..{W(1 + em)' f) - { ~ f) _
e, - ~ ~ t) "e" i-I, 2, ..., n, m
(8)
where the first factor Is the relative Jump In the marginal utility of real wealth If
a rare event occurs. An event that results In a negative Jump In the return on the
market portfolio wlll cause a positive relative Jump In the marginal utlllty of
wealth. For e, > 0 we than get , > 0, I.e. the usefulness of asset i as a hedge
against the rare event results In a lower reqUired rate of return.
Let us next say something about the practlcallmpllcatlons of (7). Our results
Indicate that If one Is to use the CAPM In evaluating the required rate of return
for a project one should attempt to take the risk premia for Jump risk Into
account. Questions of the following type should be asked. What Is the prob-
ablllty of, for example, a devaluation and what effect would It have on the return
to the project and on the return to the market portfollo? The answers should be
stated In terms of expected return to the proJect, "e" and to the market
portfollo, "em, respectively. The CAPM can then be modified along the lines of
(7) but computing e, and m and making an assessment of the coefficlent of
relative risk aversion, 'Y.
Of course, If lump risk Is diversifiable In the market portfolio we need not
worry about that risk as long as we hold the market portfolio. This leads to the
empirical part of the paper, which wl1l shed some light on this question that Is
cruclal to the relevance of the model.
3. IS THEIR JUMP RISK IN THE MARKET PORTFOLIO?
We first discuss how to test whether Jump risk Is dlverslfiable In the market
portfolio. Next follows a description of the data. The maximum likelihood
estimates and the likelihood ratio test results are then presented. Due to known
problems with the likelihood estimation for this type of model the results from
an alternative estimation method are also presented.
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

The lCAPM with Poisson jump-diffusion returns 111
3.1 Test procedure
To Investigate If there is Jump risk in the market portfolio let us look at the
market portfolio dynamics. The market portfolio consists of the market
weighted values, and equals M = 'i7-
l
w
mi
P
j
Using (1), the return on the market
portfolio can be written as
dM"
M = LWmi[JL,dt + u,dZ
,
+ E,dY - Ae,dt] (9)
I-I
If Jump risk Is diverslfiable the condition for the ICAPM to hold can be stated as
(Jarrow and Rosenfeld, 1984)
"
LW
mi
[g,d17i + E,dY - Aejdt] = 0
1"1
(10)
where g,d17i = u,dZ, - f,dl/1, I.e. dZ, has been divided up into a common factor, dl/1,
and residuals, d17,. Condition (10) says that the market portfolio shares {W
mi
17.1
must be such that the stochastic components of the returns from the assets are
eliminated, except for the common factor dl/1.
The hypothesis to be tested is the condition In (10) and if accepted we have
the return on the market portfolio,
dM
M = JLdt + fdl/1
(11)
with (9) with drift JL = "i..7.IW
mi
JLI and standard deviation f = 'i7.1wmif,. If Jump risk
is not dlverslfiable we have the alternative market return process
dM
M = JLdt + fdl/1 + roY
(12)
where f Is the standard deviation conditional on no Jump and dl/1 and dYare
Independent Wiener and Poisson processes.
The log-likelihood function corresponding to (11) is
(13)
where T is the number of returns, h is the increment of time between observa-
tions, and m, = M,/M'_I'
Now let Jumps arrive according to a Poisson process with mean number of
Jumps equal to A> O. As in the previous literature, we assume that the Jump
size, E, Is a sequence of independently and Identically distributed lognormal
random variables with parameters (0, ll). The Jump size and the Poisson
process are Independent (see Karlin and Taylor, 1981). Generally, the process
can be described as
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

112
In rot = p. + adZ +~
"
E. Bentzen and P. Sellin
(14)
The jump sizes, c", which all are Identically lognormally distributed, give the
following law for the sum: I"E. - T(nO, n ~ With the law of Adenoted by P(A),
the final process can be described as P(A)T(jL + nO, cr + nOZ), with mean time
between jumps given by E(T) = A-1T(p. + nO, cr + n ~
We can write the log-likelihood function corresponding to (12) as (Basawa and
Rao, 1980)
n
In L
u
= -nAh - '2ln(217')
(15)
Alikelihood ratio test given by LR =-2 (In L
e
- In LJ can be used to test the
hypothesis that jump risk Is dlverslfiable, with likelihood L
e
, versus the altern-
ative that jump risk Is not dlverslfiable, with likelihood L
u
' The LR has a X-
distribution with degrees of freedom equal to the difference In the number of
parameters between the two models (In our case 5 - 2 =3 d.f.). As pointed out
by Ball and Torous (1985), the Infinite sum In (15) has to be truncated so that
sufficient accuracy Is achieved. The actual truncation depends on the value of A.
The estimation was carried out In double precision and the Infinity sum was
truncated at J= 10.
3.2 Description of data
The empirical tests were performed on value-weighted Indices from 18 countries
(and a 'World' Index). The Indices used were conected from Morgan Stanley
Capital Market Indices. The data consist of dally observations from January
1985 to December 1999, which means that for each Index we have 3914 observa-
tions. Weekend returns are treated as overnight returns. Atechnical description
of the Indices can be found In Morgan Stanley (1986).
In Table 1 simple summary statistics are given for each Index. Besides means,
standard deviations, skewness, and kurtosis, we report the number of observa-
tions with respect to sigma limits. In order to shed some light on the possible
effect that the events In October 1987 may have on the analysis, the results for
1987 are reported separately. Panel Aof Table 1 contains summary statistics for
the period for 1985-1986, 1988-99, while Panel B contains statistics for 1987
only.
Table 1should be read as follows. It Is seen that the world Index has a positive
dally return of 0.0518%, a standard deviation of 0.7009%, a negative skewness of
-0.2229, and a kurtosis of 3.8217. Compared with a normal distribution we have
an empirical distribution with negative skewness and a kurtosis which Implies
that the distribution Is much more peaked (and has fatter tails) than the normal.
Anormal distribution has a skewness of zero and a kurtosis of three. We found
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

The lCAPM with Poisson jump-diffusion returns 113
Table 1.
Summary statistics of daily Morgan Stanley Capital Market Indices of 18 countries,
1985-1999
Mean Std Less than More than
Indices
(%) (%) Skewness Kurtosis ::t2*Std :t 2*Std
Panel A: Summary statistics 1985-1986, 1988-1999
World
0.0518 0.7009 -0.2229 3.8217 3464 189
Austrlia
0.0341 1.1454 -0.2569 3.3169 3469 184
Austria
0.0485 1.2389 -0.2017 7.6941 3481 172
Belgium 0.0657 1.0200 0.1820 5.6107 3483 170
Denmark
0.0574 1.1468 -0.2829 8.7698 3478 175
France
0.0771 1.1426 -0.2712 3.6408 3477 176
Germany 0.0735 1.2713 -0.5862 7.9970 3478 175
Italy
0.0648 1.4760 -0.3797 4.5881 3470 183
Japan 0.0327 1.4156 0.3918 4.8774 3454 199
Netherlands 0.0656 0.9822 -0.1964 3.1884 3468 185
Norway 0.0393 1.3561 -0.3113 5.9120 3469 184
Spain 0.0615 1.2681 -0.2605 5.5872 3481 172
Sweden 0.0845 1.3207 0.0164 5.1793 3488 165
Switzerland 0.0731 1.0715 -0.2746 4.0941 3459 194
UK 0.0485 1.0214 -0.0021 2.0535 3466 187
Canada 0.0327 0.8239 -0.6689 7.2108 3471 182
Hong Kong 0.0687 1.6669 -1.1171 25.4012 3487 166
Singapore 0.0399 1.3050 -0.2082 13.1808 3484 169
USA 0.0604 0.8680 -0.5476 6.1106 3462 191
Panel B: Summary statistics 1987
World 0.0513 1.3508 -2.3311 25.0290 256 5
Austrlia 0.0250 2.5413 -5.4338 53.4370 251 10
Austria 0.016 1.2197 -0.7628 4.1518 248 13
Belgium 0.0161 1.4610 -1.1477 11.1999 248 13
Denmark 0.0412 1.3678 -1.8768 17.8768 250 11
France -0.0623 1.6347 -0.8418 7.3617 249 12
Germany -0.1152 1.7411 -0.6481 4.7665 248 13
Italy -0.0975 1.3826 -0.5887 2.1948 250 11
Japan 0.1355 2.0011 -2.5762 30.1590 251 10
Netherlands 0.0132 1.7904 -0.8588 13.2461 249 12
Norway 0.0137 2.5474 -3.6384 37.6041 251 10
Spain 0.1084 1.8838 -0.5697 6.4745 252 9
Sweden 0.0015 1.6568 -1.0828 6.0034 246 15
Switzerland -0.0434 1.5984 -2.2825 14.3334 248 13
UK 0.1051 1.7713 -2.8193 20.6310 253 8
Canada 0.0422 1.5937 -1.8527 18.3505 253 8
Hong Kong -0.0285 2.9934 -8.6634 109.6533 258 3
Singapore 0.0032 2.6248 -4.4162 45.3670 254 7
USA 0.0023 2.0723 -5.1611 57.9661 254 7
The summary statistics are reported in percentage terms. The final two columns count the number of
returns less than (more than) two times the standard deviation.
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

114 E. Bentzen and P. Sellin
3464 observations with a return less than two times the standard deviation and
189 observations with a return above two times the standard deviation. Looking
at 1987, in panel B, It Is seen that the dally mean in the world index Is 0.0513%,
the standard deviation Is 1.3508%, with a skewness of -2.3311, and a kurtosis at
22.029. We found 256 returns less than two times the standard deviation and five
returns above two times the standard deviation.
The computed standard deviations are quite large. With these large standard
deviations nothing significant could be said about the mean. This Is the case for
both data sets.
The computed skweness should be compared with a normal distribution,
where the skewness Is zero. For the period excluding 1987 most Indices are
found to be negative. Only three Indices have a positive skewness, Belgium
(0.18), Japan (0.39), and Sweden (0.01). looking only at 1987 It Is seen that all
indices have a negative skewness. It is also seen that very large values of
skewness are reported In 1987. Hong Kong has a positive skewness (0.3918) for
the period that excludes 1987, but shows negative skewness for 1987 (-2.5762).
The largest negative skewness is found In 1987 for Hong Kong (-8.6634).
The kurtosis measures indicate that the return distributions for some indices
are peaked. If we look at 1987 alone the values of the kurtosis are very large, the
largest being for Hong Kong (109.6533). Three distributions are less peaked In
1987, Austria (4.1519), Germany (4.7665) and Italy (2.1948).
If we let a possible Jump be Identified by a return whose absolute value is
above two times the standard deviation, there are several possible Jumps In the
Indices according to the last column In the table. Not all of these jumps belong
to 1987, but a relatively large number do. It seems reasonable to make the
empirical Investigation In two parts. One which Includes 1987 and a second
which excludes 1987 and then compare the two Investigations.
3.3 Estimation of parameters
The parameters In the model have been estimated using the data described
in the previous section. Table 2 covers the period from 1985 to 1999 and the
estimated parameters from the two stochastic processes (11) and (12) are
displayed together with the corresponding standard errors and the llkellhood
ratio tests.
l
In Table 2 it is seen that the estimates of the Poisson jump process have a
mean number of jumps, A, that are all significantly different from zero. This
suggest the existence of Infrequent discrete movements. The mean number of
Jumps per day, which can also be Interpreted as the probability of a Jump per
day, for Austria (0.292), Italy (0.467), Japan (0.594), Hong Kong (0.261) and USA
(0.677) are large numbers compared with those from other studies. Beckers
(1981) finds a 12% probability of a Jump per day, while Ho et al. (1996) find a 20%
probability for the period 1984-1986 and a 10% probability for the period
1987-1989. Both studies use US data. For the US index we find a 67% probability
I The estimations of the maximum likelihood estimators have been carried out using the sub-
routine VF13AD from Harwell (1989). Standard errors are obtained from the diagonal of the Hessian
(Rao, 1965).
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

The lCAPM with Poisson jump-diffusion returns
115
Table 2.
Estimates of the mixed Poisson Jump-diffusion model and the simple Wiener
process model of daily returns to the stock market indices of 18 countries, 1985-1999
Weiner-Poisson jump process
Weiner process
1985-1999
JL
CT A e
P-
CT LA. test
World
0.082 0.503 0.263 -0.104 1.035 0.052 0.761 36460
(0.008) (0.003) (0.031) (0.003) (0.316) (0.001)
(0.009)
Australia 0.085 0.997 0.063 -0.698 2.806 0.033 1.286 34251
(0.023) (0.022) (0.013) (0.051) (0.855) (0.001)
(0.015)
Austria 0.046 0.804 0.029 0.023 1.702 0.045 1.238 33096
(0.011) (0.005) (0.217) (0.010) (2.080) (0.001) (0.014)
Belgium 0.076 0.803 0.166 -0.047 1.627 0.062 1.055 35248
(0.012) (0.006) (0.087) (0.012) (1.298)
(0.001) (0.012)
Denmark 0.081 0.810 0.229 -0.080 1.660 0.056 1.163 34009
(0.013) (0.006) (0.056) (0.006) (0.643) (0.001)
(0.013)
France 0.118 0.896 0.201 -0.214 1.669 0.068 1.182 34546
(0.014) (0.006) (0.026) (0.008) (0.579)
(0.001)
(0.013)
Germany 0.126 0.952 0.183 -0.311
2.022 0.061 1.308 33671
(0.014) (0.006) (0.016) (0.010)
(0.516)
(0.001) (0.015)
Italy 0.094 0.949 0.467 -0.062
1.613 0.054 1.470 31868
(0.014) (0.006) (0.094) (0.006)
(0.593)
(0.001) (0.017)
Japan 0.009 0.751 0.594 0.068 1.574 0.040 1.462 30301
(0.012) (0.004) (0.071) (0.002)
(0.436) (0.001)
(0.017)
Netherlands 0.105 0.776 0.141 -0.269 1.821 0.062 1.055 35137
(0.012) (0.004) (0.014) (0.009)
(0.509)
(0.001) (0.012)
Norway 0.067 0.965 0.215 -0.091
2.225 0.038 1.465 32093
(0.016) (0.006) (0.053) (0.008)
(0.546)
(0.001)
(0.017)
Spain 0.092 0.987 0.135 -0.138
2.338 0.065 1.318 33711
(0.016) (0.008) (0.034) (0.010)
(0.847)
(0.001)
(0.015)
Sweden 0.111 1.025 0.134 -0.174
2.345 0.079 1.346 33703
(0.016) (0.008) (0.030) (0.010)
(0.867)
(0.001)
(0.015)
Switzerland 0.122 0.831 0.159 -0.220
1.702 0.065 1.114 34939
(0.013) (0.006) (0.019) (0.009)
(0.512)
(0.001)
(0.013)
UK 0.088 0.883 0.109 -0.273 1.817
0.052 1.087 35567
(0.013)
(0.006) (0.015) (0.016)
(0.722)
(0.001)
(0.012)
Canada 0.069 0.571 0.211 -0.152
1.404 0.033 0.896 35205
(0.009) (0.003) (0.019) (0.004)
(0.299)
(0.001) (0.010)
Hong Kong 0.124 0.949 0.261 -0.48
2.535 0.062 1.786 29347
(0.015)
(0.005) (0.029) (0.005)
(0.329)
(0.001)
(0.020)
Singapore
0.061 0.790 0.214 -0.070
2.342 0.037 1.431 31006
(0.013) (0.004) (0.039) (0.005)
(0.337)
(0.001)
(0.016)
USA 0.070 0.437 0.677 -0.006
0.955
0.057 9.994 31725
(0.007)
(0.002) (0.187) (0.003)
(0.368)
(0.001)
(0.011)
Equations 12 and 13 are estimated using daily returns, where the mean rate of return is given by IL,
while tr Is the standard deviation of the return, AIs the mean number of jumps per day, (J and 6are the
expected value and standard deviation of the logarithm of the jump amplitude. The estimated
parameters IL, tr, 8 and 6are reported In percentage terms. Standard errors are reported in parenthesis
below the point estimates (also In percentage terms). The final column gives the likelihood ratio test
for the hypothesis that Jump risk Is diversifiable versus the hypothesis that it is not.
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

116
E. Bentzen and P. Sellin
Table 3.
Estimates of the mixed Poisson Jump-diffuslon model and the simple Wiener
process model of daily returns to the stock market Indices of 18 countries, 1985-1986,
1988-1999
Weiner-Poisson jump process Weiner process
1985-1999 p. U' A
6 8 p. U' LA. test
World 0.080 0.436 0.512 -0.050 0.754 0.052 0.701 34057
(0.007) (0.003) (0.063) (0.002) (0.314) (0.001) (0.008)
Australia 0.082 0.822 0.370 -0.111 1.287 0.034 1.145 32008
(0.013) (0.006) (0.059) (0.004) (0.579) (0.001) (0.013)
Austria 0.045 0.804 0.291 0.036 1.707 0.048 1.239 30879
(0.016) (0.005) (0.218) (0.023) (3.615) (0.001) (0.015)
Belgium 0.072 0.785 0.199 -0.004 1.419 0.066 1.020 33164
(0.012) (0.006) (0.510) (0.024) (2.139) (0.001) (0.012)
Denmark 0.086 0.778 0.308 -0.074 1.455 0.057 1.147 31632
(0.013) (0.005) (0.068) (0.005) (0.596) (0.001) (0.013)
France 0.131 0.837 0.344 -0.139 1.301 0.077 1.143 32176
(0.013) (0.006) (0.049) (0.005) (0.573) (0.001) (0.013)
Germany 0.130 0.912 0.246 -0.199 1.721 0.073 1.271 33671
(0.014) (0.006) (0.031) (0.008) (0.533) (0.001) (0.015)
Italy 0.098 0.926 0.506 -0.044 1.585 0.065 1.476 29525
(0.014) (0.006) (0.123) (0.006) (0.634) (0.001) (0.017)
Japan -0.009 0.714 0.680 0.071 1.456 0.033 1.416 28337
(0.012) (0.004) (0.067) (0.001) (0.336) (0.001) (0.017)
Netherlands 0.113 0.705 0.283 -0.151 1.266 0.066 0.982 33031
(0.011) (0.005) (0.033) (0.004) (0.483) (0.001) (0.011)
Norway 0.045 0.876 0.365 0.008 1.674 0.039 1.356 30266
(0.013) (0.006) (0.570) (0.016) (1.092) (0.001) (0.016)
Spain 0.086 0.959 0.144 -0.118 2.158 0.062 1.268 31755
(0.016) (0.008) (0.043) (0.011) (0.982) (0.001) (0.015)
Sweden 0.105 1.038 0.126 -0.094 2.265 0.084 1.321 31743
(0.017) (0.009) (0.056) (0.018) (1.510) (0.001) (0.015)
Switzerland 0.115 1.192 0.013 -3.907 1.169 0.073 1.071 32459
(0.020) (0.019) (0.001) (0.517) (0.434) (0.001) (0.013)
UK 0.085 0.787 0.314 -0.098 1.150 0.049 1.021 33166
(0.012) (0.006) (0.066) (0.005) (0.824) (0.001) (0.012)
Canada
0.068 0.544 0.269 -0.120 1.159 0.033 0.824 33576
(O.OOg)
(0.003) (0.027)
(0.003) (0.325) (0.001) (0.010)
Hong Kong
0.116 0.927 0.278 -0.123 2.460 0.069 1.667 28079
(0.015)
(0.005) (0.035) (0.005) (0.345) (0.001) (0.020)
Singapore
0.047 0.734 0.278 -0.040
1.960 0.040 1.305
29630
(0.012) (0.004) (0.319)
(0.014) (0.553) (0.001) (0.015)
USA 0.062 0.385 0.854 -0.003 0.821 0.060 0.868 30387
(0.006) (0.002) (0.184)
(0.003) (0.545) (0.001) (0.010)
Equations 12 and 13 are estimated using daily returns. where the mean rate of return is given by IJ.,
while fT Is the standard deviation of the return, AIs the mean number of jumps per day, 6and 8are the
expected value and standard deviation 01 the logarithm 01 the jump amplitude. The estimated
parameters J.t. fT, 6and 8are reported In percentage terms. Standard errors are reported In parenthesis
below the point estimates (also In percentage terms). The final column gIves the likelihood ratio test
for the hypothesis that jump risk Is diversifiable versus the hypothesis that It Is not.
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

The ICAPM with Poisson jump-diffusion returns 117
for the period 1985-1999. In the next section we show that this difference is due
to the differences in the estimation methods used.
Estimates of the jump size show an expected positive value for two indices,
but for most indices a negative jump size is found. The estimated standard
deviations for the jump size are all very large, so nothing unambiguous could be
read from these numbers. The estimates for the diffusion part shows all positive
values for the mean. But again the estimated standard deviations are very large.
The simple Wiener process shows positive means in all indices, but also with
very large standard deviations.
The likelihood ratio tests are all significant compared with a Kwith three
degrees of freedom, which clearly indicate the existence of jumps in the Indices.
So while the estimated values for the probabilities of jumps are larger than in
previous studies, it is clear that the model with a jump component gives a much
better fit to the data. The two estimated models show that It Is not possible to
diversify jump risk. With a computed likelihood ratio test that Is significant at all
levels, we are able to reject the hypothesis that jump risk is diversifiable in the
market portfolio.
As indicated in the simple data description In Table I, it is possible that the
turbulence during the single year 1987 could be a major cause of the jumps in
the indices. In Table 3 we have re-estimated the two models, excluding the data
for 1987. The largest mean numbers of jumps are found in USA (0.854), Japan
(0.68) and UK (0.314). The smallest number of jumps is found in Switzerland
(0.013). The jump size in Austria (0.036) and Japan (0.071) are both positive. The
jump size in all other indices are negative. This means that when a jump occurs
In most indices one would expect this with a negative sign. The negative jump
size in Switzerland (-3.907) is the largest negative jump size estimated for any
Index. But it is not outweighed by a large positive drift (0.115) In the diffusion
part of the model. All Indices show a positlve drift in the diffusion part, i.e. a
positive trend Is found In all indices. The simple Wiener process does not give
any significant results. The means are all positive but not significantly different
from zero.
The likelihood ratio tests are all significant compared with a K with three
degrees of freedom. This result shows that even for the period that excludes
1987, It Is not possible to diversify jump risk. We find a significant number of
jumps In all Indices.
It Is also Interesting to compare the Jump component's variance as a share of
the total variance, I.e. Ad/(eil + A ~ for the two periods. If we look at the World
Index for the period excluding 1987 the share Is 60%, and If we include 1987 the
jump component's share of the total variance falls slightly to 58.7%. Thus, the
single year 1987 does not appear to be Important for our overall results.
3.4 An alternative estimation method
The estimation of the mixed jump-diffuslon model is subject to serious estima-
tion problems. From inspection of Equation 15 it Is clear that it is not easy to
identify a jump. The likelihood function (and its derivatives) are highly non-
linear and contain an Infinite sum. This has led some researchers, starting with
Press (1967), to employ a version of the method of moments known as the
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

118
E. Bentzen and P. Sellin
cumulant matching method as an alternative to the maximum likelihood
method.
We wl11 folJow Beckers (1981) In assuming that the mean jump amplitude Is
zero. which Implies that our theoretical model reduces to the standard lCAPM.
This gives us one less parameter to estimate. Even though the mean jump
amplitudes are significant In all cases. as can be seen In Table 2. they are small In
most cases and we should obtain more accurate estimates of the Jump prob-
abilities by using Beckers' approach. The remaining parameters are estimated
as
p. = K
1
cr = K
2
- K2J3K
6
fjZ = KrJ5K.
A = 5 K ~ 3 K l
where K, Is the ith cumulant of the distribution.
The estimated parameters are presented In Table 4. The jump components
share of total variance Is 30% for the World Index. The probablllty of a jump per
day ranges from a low of 0.002945 (USA) to a high of 0.081231 (Sweden) and Is
Table 4. Methods of moments parameter estimates 1985-1999
1985-1999 JL u A 8
Wortd 0.0518 0.6348 0.0128 3.7380
Australia 0.0335 1.1134 0.0032 11.4292
Austrta 0.0453 1.0225 0.0292 4.0885
Belgium 0.0624 0.8434 0.0381 3.2637
Denmark 0.0563 0.9029 0.0370 3.8193
France 0.0678 0.9032 0.0670 2.9567
Germany 0.0609 1.0783 0.0293 4.3421
Italy 0.0540 1.1312 0.0678 3.6110
Japan 0.0396 1.2616 0.0141 6.2231
Netherlands 0.0621 0.8424 0.0308 3.6393
Norway 0.0375 1.2868 0.0052 9.6931
Spain 0.0647 0.9555 0.0726 3.3754
Sweden 0.0789 0.9750 0.0812 3.2649
Switzertand 0.0654 0.9076 0.0332 3.5675
UK 0.0523 0.9640 0.0099 5.0874
Canada 0.0333 0.6997 0.0223 3.7473
Hong Kong 0.0622 1.4549 0.0044 15.6677
Singapore 0.0374 1.1777 0.0068 9.8586
USA 0.0566 0.8459 0.0029 9.6862
Equation 14 Is estimated using daily returns for computing the moments and cumulants. 1
Is the mean rate of return, q Is the standard deviation of the return, " Is the mean number of
lumps per day, and ~ Is the standard deviation of the logarithm of the jump amplitUde. The
estimated parameters 1, q and 8 are reported In percentage terms.
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

The ICAPM with Poisson jump-diffusion returns
119
on average 0.031. These results are more In line with the jump probabilities
found In Beckers (1981) and Ho et al. (1996). Of course this estimation method
Is not free of problems. Beckers (1981) and Ball and Torous (1983) obtain
several negative variance estimates using this method. Beckers then Imposes
the restrictions that all 47 stocks investigated must have the same mean number
of jumps, after which all variance estimates become positive. We do not have
that problem with our country Indices, perhaps because they are broad indices
and not the price of Individual stocks. A further drawback with this method is
that standard errors of the estimates are not readily available.
4. CONCLUSION
This paper has Investigated the Intertemporal Capital Asset Pricing Model with
returns that follow mixed jump-diffusion processes. We added just the number
of restrictions as needed to give an explicit solution for capital market equilib-
rium. It was shown that the CAPM relation holds only after expected returns
have been adjusted for jump risk premia, except In two special cases. The first
case Is when jump risk is dlverslfiable In the market portfolio. The second case
Is when Investors have logarithmic utility.
In estimating the model we used Indices from 18 countries covering the
period 1985 to 1999. We come to the same conclusions as Jarrow and Rosenfeld
(1984) did for US data for an earlier period. namely that (1) the market portfolio
contains a Jump component, and (2) risk Is not diversifiable In the market
portfolio.
Our study also Illustrates the problems Inherent In estimating a mixed jump-
diffusion model. Maximum likelihood and the cumulant matching method give
very different results when estimating the mean number of Jumps. However.
both methods agree that the Jump component's share of total variance Is hlgh-
30% according to the method of moments estimates and 60% for the maximum
likelihood estimates (59% If 1987 Is excluded from the sample).
APPENDIXES
A Construction of portfolio shares
Let N, be the number of company i shares the Investor holds (i = 1,2, ..., n). If
the Investor's only Income comes from his portfolio of shares and a risk-free
asset (i = 0). his wealth wlll evolve according to
n n
dW = 'LN,dP, - Cdt = 'LN,dP, + NodP
o
- Cdt
'-0 '-I
where Cdt Is the flow of consumption. We can rewrite this as
n n
dW
N,P, dP
,
( N,P,)
=W LJ - - - W 1 - LJ - nlt - Cdt
W P W
'-1' I-I
(16)
(17)
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

120
E. Bentzen and P. Sellin
where r Is the return on the risk-free asset. Defining the portfollo share w, = N,P,!
I, we get
n dP ( n)
dW = WLw,y - W 1 - LW, rdt - Cdt
'-1' '-I
= iw,w(rlJ' - rdt) + (rW - C)dt
'-I '
which Is Equation 4 In the main text.
B Deriving the equilibrium with fixed Jump size
We begin by defining the maximum value function
Jel, t) = max {E
t
J.-V(C(s) , S)dS}.
IC.w);" t
(18)
(19)
The Hamllton-Jacobl-Bellman OIJB) equation for this problem Is (see Malllaris
and Brock, 1982: Chapter 2, Sectlon 12),
0= max(1 - 'Y)-IC'-,. + J,(lY, f) + Jw(Jf. t)(WwT(v - Ae) + Wr - CI
C.w
+ t)W2w
T
fiw + f"A(J(W + Ww
T
E(a), f) - J(l-Y. f)lf(a)da} (20)
where J
x
Is the partial derivative with respect to argument x, I(a) Is the density
function for the Jump amplitudes, and the other notation Is the following:
w = en x 1) vector of portfolio shares (wT Is the transpose of w);
v = (n x 1) vector of excess rate of return, I.e. = IL, - r for asset i;
E = en x 1) vector of Jump amplltudes;
e = (n x 1) vector of expected Jump amplitudes;
n = (n x n) covariance matrix of asset rates of return.
Under assumption 7 the Jump amplitudes are nonstochastlc, E = e. We seek a
solution to the following set of equations, where a hat denotes an optimal
control:
o= t(l - 'Y)-IC
1
-,. + J,(lY, f) +Jw(lY, t)[WwT(v - Ae) + Wr - C)
+ I)W2W
T
nw + A[J(W + WwTe, I) - J(J-Y, t)]} (21)
a!:} = c-,. - Jw<1, t) = 0 (22)
=Jw<1, 1)(1' - Ae) + t)wnw + Jw(W+ WwTe, I)e =0 (23)
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

121
(24)
The ICAPM with Poisson jump-diffusion returns
A solution is conjectured to be
J(W') = pW'-Yexp(-pI)
where p is a constant. Plugging in the proposed solution we get
p = _1_ {! (p _ h - A[(1 + wTe)l-Y - I
D
}-Y (25)
. 1-""
which will be constant If the optimal portfolio, W, is constant over time. The
solution to the investor's problem is well-defined If the following growth con-
dition holds,
p> h + A[(1 + wTe)I-Y - 1] (26)
where h is defined as
(27)
We find that the Investor's optimal portfolio rule is Implicitly given by the
following first-order condition:
(28)
Since there are no tlme-dependent variables In this equation we conclude that
the optimal portfolio wlll be constant through time. This Is consistent with the
assumption that p is a constant and thus the conjectured solution In (24) Is
Indeed valid. Note that for A =0 the optimal portfolio in (28) reduces to the
usuailCAPM optimal portfolio, w = ,,-In-Iv.
Using assumption 81n the main text, we can substitute W =w
m
and rearrange
(28) to get
II = ,.Gw
m
+ A[(1 + - l]e (29)
Premultlplying (29) by we get
(30)
(32)
Simplifying the notation,
JIm = + (31)
where the notation can be found after Equation 7 in the main text. Combining
(29) and (31) we get
1
v = O! (JIm - +
m
>From this equation we get the scalar forms (7) in the main text.
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

122 Eo Bentzen and P. Sellin
C Deriving the equilibrium with stochastic Jump size
The HJB equation Is the same as In the problem with a fixed Jump size. However,
the solution will now have to be valid for the following set of equations:
0= {(I - ,.rICS-" + J,(W; t) +JwCW; t)[WwT(v - Ae) + Wr - C]
+ t)W2w
T
oW+ fAA[J(W + WW
T
(a), I) - JOY. I)]f(a)da} (33)
= C-" - t) = 0
t! = t)(v - Ae) + t)WOw
+ AfA J(W + WWT(a), I)(a)f(a)da = 0
(34)
(35)
where a tilde denotes an optimal control. The solution should be of the same
form as In (24). Plugging In that solution, we get
p= 1 : ,. {; (p - h - AL[(l + w
T
(a))l-Y - l]f(a)da)r
y
(36)
The Investor's optimal portfolio Is given by
w- .; [0-
1
(1' - eA) - A[(l + w
T
(a))l-,.n-
I
(a)f(a)da] =0 (37)
In exactly the same way as for the case with a fixed Jump size, we can derive the
JCAPM relation,

where the risk premia for the Individual assets are now given by
gl = A[e
l
+ [(1 + w
T
(a))I-,.O-lf/a)f(a)da]
while the risk premium on the market portfoUo Is given by
gm = A + fA[(1 + w
T

(38)
(39)
(40)
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

The ICAPM with Poisson jump-diffusion returns
123
ACKNOWLEDGEMENTS
We wish to thank Marten Blix, Stephen Satchell, Lars E.O. Svensson, Ingrid
Werner, and the participants at seminars at the Institute for Econ-
omic Studies at Stockholm University, and European Finance Association Meeting
in Copenhagan, as well as two anonymous referees for valuable comments.
REFERENCES
Akglray, V. and Booth, G.G. (1986) Stockprlce processes with discontinuous time paths:
an empirical examination, Financial Review, 21, 163-184.
Akglray, V. and Booth, G.G. (1987) Compound distribution models of stock returns: an
empirical comparison, Journal of Financial Research, 10, 259-280.
Ball, C.A. and Torous, \VoN. (1983) A simplified Jump process for common stock returns,
Journal of Financial and Quantitative Analysis, 18, 53-65.
Ball, C.A. and Torous, W.N. (1985) On lumps In common stock prices and their Impact on
call option pricing, Journal of Finance, 40, 155-173.
Basawa, I.V. and Rao, P. (1980) Statistical Inference for Stochastic Processes. London:
Academic Press.
Bates, D.S. (1991) The Crash of '87: Was It expected? The evidence from options markets,
Journal of Finance, 46, 1009-1044.
Bates, 0.5. (2000) Post '87 Crash fears In S&P 500 futures options, Journal of Econo-
metrics, 94, 181-238.
Beckers, S. (1981) A note on estimating the parameters of the diffusion-Jump model of
stock returns, Journal of Financial and Quantitative Analysis, 16, 127-140.
Belnert, M. and Trautmann, S. (1991) Jump-dUfuslon models of German stock returns: a
statistical Investigation, Statistical Papers, 32, 269-280.
Brorsen, B. and Yang, S. (1994) Nonlinear dynamics and the distribution of dally stock
Index returns, Journal of Financial Research, 42, 187-203.
Chamberlain, G. (1988) Asset pricing In multi period securities markets, Econometrica, 56,
1283-1300.
Cox, lC. and Ross, S.A. (1976) The valuation of options for alternative stochastic
processes, Journal of Financial Economics, 3, 145-166.
Feng, C. and Smith, S.D. (1997) Jump risk, time-varying risk premia, and technical trading
profits, Federal Research Bank of Atlanta Working Paper No. 97-17.
Fisher, A. (1999) Multivariate stock returns around extreme events: a reassessment of
economic fundamentals and the 1987 market crash, Department of Finance Working
Paper No. 00-071, New York University.
Harwell Subroutine Library (1989), Harwell Laboratory, Oxfordshlre.
Ho, M.S., Perraudln, W., and Sorensen, RE. (1996) A continuous-time arbitrage-pricing
model with stochastic volatility and Jumps, Journal ofBusiness andEconomicStatistics,
14,31-43.
Jarrow, R.A. and Rosenfeld, E.R. 91984) Jump risks and the lntertemporal Capital Asset
Pricing Model, Journal of Business. 57, 337-351.
Jorlon, P. (1988) On Jump processes In the foreign exchange and stock markets, Review
of Financial Studies, 1,427-445.
Karlin, S. and Taylor, H.M. (1981) A Second Course in Stochastic Processes. New York:
Academic Press.
KllIc, 0., Tufte, D., and Hassan, M.K. (1999) The 1994-1995 Mexican currency crisis and
U.S. bank stock returns, Journal of Financial Services Research, 16,47-60.
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3

124 E. Benlzen and P. Sellin
KIm, M.H., Oh, Y.H., and Brooks, R. (1994) Are Jumps In stock returns dlverslfiable?
Evidence and ImpllcaUns for option pricing. Journal 01 Financial and Quantitative
Analysis, 29. 609-631.
Kou, S.G. (2000) A Jump-dlffuslon model for option pricing with three properties:
leptokurtic feature. volatility smile, and analytical tractabUlty. Mlmeo, Columbia
University: www.leor.columbla.edu/-kou.
Lelsen, D.PJ. (1999) Valuation of barrier options In a B1ack-Scholes setup with Jump risk.
University 01 Bonn Discussion raper No. 8446.
Mal1larls. A.G. and Brock, WA (1982) Stochastic Methods In Economics and Finance.
Amsterdam: North-Holland.
Merton. R.C. (1973) An Intertemporal Capital Asset Pricing Model. Econometrica, 41
. 867-887.
Merton, R.C. (1976) Option pricing when underlying stock returns are discontinuous,
Journal o( Financial economics. 3, 125-144.
Merton, R.C. (1990) Continuous-Time finance. Cambridge, MA: D1ackwell.
Morgan Stanley Capital International Perspective, April 1986.
Nlmalendran. M. (1994) Estimating the effects of Information surprises and trading on
stock returns using a mixed Jump-dlffuslon model, Review o( Financial Studies, 7,
451-473.
Oldfield, G., Rogalski. R.. and Jarrow, R. (1977) An autoregressive Jump process for
common stock returns. Journal o( Financial Economics, 5, 389-418.
Press, SJ. (1967) Acompound events model for security prices, Journal o( Business, 40,
317-335.
Rao, C.R. (1965) Linear Statisticalln(erence and Its Applications. John Wiley &Sons.
Scott. L.O. (1997) Pricing stock options In a Jump-dllfuslon model with stochastic
volatl1lty and Interest rates: applications 01 Fourier Inversion methods, Mathematical
Finance. 7, 413-26.
Trautmann, S. and Belnert, M. (1999) Impact of stock price Jumps on option values, In
Buhler. W., Hax, H., and Schmidt, R. (eds), Empirical Research on the German Capital
Market. Heidelberg: Physlca-Verlag.
D
o
w
n
l
o
a
d
e
d

b
y

[
I
N
A
S
P

-

P
a
k
i
s
t
a
n

(
P
E
R
I
)
]

a
t

0
3
:
5
8

2
4

S
e
p
t
e
m
b
e
r

2
0
1
3