Rational functions: an alternative approach to asset pricing



Chakraborty N, Elgammal MM & McMillan D (2019) Rational functions: an alternative approach to asset pricing. Applied Economics, 51 (20), pp. 2091-2119.

This paper shows that asset prices are linear polynomials of various underlying explanatory factors and asset returns being ratios of these polynomials, are rational functions that do not add linearly when averaging. Hence, average returns should be modeled based on stock prices. However, continuous returns may be treated as approximately linear across time and modeled directly. Our new Rational Function (RF) models, empirically outperform the traditional asset pricing models like the Capital Asset Pricing Model (CAPM) and the Fama–French three and five-factor models for both average and continuous returns. Moreover, the RF theory also provides a model to estimate the asset volumes. The average change in asset volumes together with average returns provide the estimates for average change in market values of assets. Thus, the RF model approach can be used to select assets that provide either highest returns for profit maximization or highest change in market values for wealth maximization for given levels of risk.

Asset pricing; average returns; rational function model; CAPM, Fama French 3 and 5 factor models; asset volumes

Applied Economics: Volume 51, Issue 20

Publication date28/02/2019
Publication date online07/11/2018
Date accepted by journal07/11/2018

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Professor David McMillan

Professor David McMillan

Professor in Finance, Accounting & Finance