The 2007-09 financial crisis challenged many long-standing beliefs about asset markets. For example, it raised questions about the applicability of the law of one price, it coincided with a period of extraordinary house price volatility, and it witnessed changing patterns of asset demand on the part of households and financial institutions alike. Over the last decade, researchers in the Asset Pricing Program have carried out a wide range of studies that are motivated by, or try to respond to, these challenges.
This report focuses on studies that exemplify post-crisis research on these three specific developments. The report is not a comprehensive review of research in the three areas, but is rather a collection of illustrative studies. Many other related papers have been distributed in the NBER Working Papers series.
Exploring Violations of the Law of One Price
The law of one price holds that two investment strategies that have exactly the same payoffs in the future should have the same value today. This principle is at the core of asset pricing theory and is usually taught at the beginning of any course in finance. Before the crisis, the law of one price was extraordinarily useful for thinking about financial markets. It was hard to come up with examples of buy-sell strategies that would generate profitable arbitrages, at least after accounting for the transaction costs that would be involved in trading based on these strategies. This suggested that violations of the law of one price did not exist, or that if they did, they were short-lived and quickly arbitraged away.
The crisis profoundly changed this situation, as the law of one price appeared to be violated in many settings. Why? The standard explanation has been weak balance sheets: Financial institutions were aware of the arbitrage opportunities but were unable to take the positions necessary to eliminate them. Some violations have persisted and are still observed today, even though balance sheets of financial institutions have recovered.
There have been particularly salient questions about price determination in foreign exchange markets. In these markets, the law of one price implies the covered interest rate parity (CIP) condition. It compares two investment strategies that do not involve risk. For example, one might be investing U.S. dollars domestically at the short-term interest rate, while the other could be investing dollars in Switzerland at the same maturity. In the latter case, the investor would exchange dollars for Swiss francs today, invest the francs at the Swiss short-term rate, and then convert them back into dollars at the current futures exchange rate. The CIP condition states that the return on these two strategies should be the same.