Islamic Capital Markets: Theory and Practice

Chapter 7

The Consumption-Based Pricing Model

The purpose of this chapter is to analyze capital asset pricing using the intertemporal-consumption model. This approach aims to determine the price of a capital asset in terms of investor’s intertemporal choice of his future consumption as in the case of retirement planning and social security contributions. The consumption-based pricing model is called the equilibrium pricing model because it applies the standard consumer utility maximization model under budget constraint and derives first-order conditions for equilibrium. From the first-order optimization conditions, the model shows the price of an asset to be equal to its expected discounted future payoffs; the stochastic discount factor is the marginal rate of substitution between present and future consumption. The consumption-based model shows the equivalence of pricing payoffs and returns, and enables us to derive the capital asset pricing model (CAPM), portfolio theory and mean-variance efficiency frontier, and risk-neutral pricing. This chapter stresses equivalence of asset pricing methods under uncertainty; each method implies the others. For instance, risk-neutral pricing should be free of arbitrage and should satisfy the optimality conditions of investors’ choices. The chapter also addresses the equity premium and interest rate puzzles and attempts to resolve the puzzles.

The merit of the consumption-based asset pricing is to relate asset pricing to economic growth and ...