The seeds of this book were planted over fifteen years ago, at the very start of our professional careers. While studying financial economics, and as we began to leach it, we discovered several excellent textbooks for financial theory-Duffie (1992), Huang and I.itzenberger (1988), and lngersoll (1987), lor example-but no equivalent textbook for empirical methods.

During die same period, we participated in research conferences on Financial Markets and Monetary Economics, held under the auspices of the National Bureau of Economic Research in Cambridge, Massachusetts. Many of die papers that captured our attention at these meetings involved new econometric methods or new empirical findings in financial economics. We fell that diis was some of the most exciting research being done in finance, and that students should be exposed to this material al an early slage.

In 1989 we began to discuss die idea of writing a book thai would cover econometric methods as applied to finance, along with some of ihe more prominent empirical results in this area. We began writing in earnest in 1991, completing this arduous project five years and almost six hundred pages later. This book is considerably longer than we had originally planned, but we have finally overcome the temptation to include just one more new topic, and have put our pens to rest. Of course, the academic literature has evolved rapidly while we have been writing, and it continues to do so even as this book goes to press. We have attempted to provide broad coverage, but even so, there are many subjects that we do not touch upon, and many others dial we can only mention in passing.

We owe many more debts-personal and intellectual-ihan we can possibly acknowledge. Throughout our professional careers our colleagues and mentors have offered us advice, debate, inspiration, and friendship; we wish to thank in particular Andy Abel, Ben Bernanke, Sieve Cect belli,John Cox, Angus Deaton, Gene Fama, Bruce Grundy, Jerry 1 lausman, Chi-fu Huang, Mrrvyn King, Nobu Kiyolaki, Pele Kyle, Greg Mankiw, Bob Merlon, Whitney Newev, BobShiller. Iunloliin mii.1 Лги,.1,1 7,-11.....

Many individuals have also provided us with invaluable continents and discussions regarding the contents and exposition of this book. We thank David Hat kits, Nick Harhcris, David Ha it, David Hates, Ken Hcchmaun, Dim-ilits Hertsiuias, Tim Hollerslcv, Peter (!hiisloffcrsen, Susan Kerr Cluislof-lersen, Ccorgc Couslanlinidcs, John Cox, Xavier Cabaix, Lorenzo Gior-gianni, Jeremy Cold, Lars 1 lansen, Campbell 1 Iarvcy.John 1 leaton, I.udger 1 lentschel, Roger I luang, Ravi Jagannathan, Shmuel Kandcl, Cautam Kaul. Jung-Wook Kim, Todd Milton, Dan Nelson, Amlan Roy, Hob Shiller, Мак Shivers, Robert Slambaugh, Tom Stoker, Jean-I.uc Vila, Jiang Wang, and ihe Ph.D. students at I larvard, MIT, Princeton, and Wharton on whom this material was test-marketed and relined.

We have relied heavily on the able research assistance ol Petr Adatnck. Sangjoon Kim, Martin I.etlau, Terence I.itn, Consianlin Pelrov, Chunsheng /.lion, and parlitularly Mall Van Vlack and Luis Viceira, who undertook the difficult tasks olproofreading the manuscript and preparing the index.

We arc grateful to Stephanie I logue for her great skill and care in preparing the electronic version of this manuscript, and the typesetters ,it Archetype for producing the final version of the book.

We thank Peter Dougherty, our editor at Princeton University Press, lor his patience, encouragement, and support throughout this project.

Several organizations provided us with generous support during various stages of this books gestation; in particular, we thank Hatterymarch Financial Management, the National Hureau of Economic Research, the National Science Foundation, the John M. Olin Foundation, the Alfred P. Sloan Foundation, and research centers at Harvard, MIT, Princeton, and Wharton.

And finally, we owe more than we can say to the support and love of our families.

JVC AW i. ACM

Introduction

Financial economics is a highly empirical discipline, perhaps die most empirical among the branches of economics and even among the social sciences in general. This should come as no surprise, for financial markets are not mere figments of theoretical abstraction; they thrive in practice and play a crucial role in the stability and growth of the global economy. Therefore, although some aspects of the academic finance literature may seem abstract at first, there is a practical relevance demanded of financial models that is often waived for the models of other comparable disciplines.1

Despite the empirical nature of financial economics, like the other social sciences it is almost entirely nonexperimental. Therefore, the primary method of inference for the financial economist is model-based statistical inference-financial econometrics. While econometrics is also essential in other branches of economics, what distinguishes financial economics is the central role that uncertainty plays in both financial theory and its empirical implementation. The starting point for every financial model is the uncertainty facing investors, and the substance of every financial model involves the impact of uncertainty on the behavior of investors and, ultimately, on market prices. Indeed, in the absence of uncertainty, the problems of financial economics reduce to exercises in basic microeconomics. The very existence of financial economics as a discipline is predicated on uncertainty.

This has important consequences for financial econometrics. The random fluctuations that require the use of statistical theory to estimate and test financial models are intimately related to the uncertainty on which those models are based. For example, the martingale model for asset prices has vei-y specific implications for the behavior of test statistics such as the autocorrelation coefficient of price increments (see Chapter 2). This close connection between theory and empirical analysis is unparalleled in the

Ilei ostein (llJ(J2) provides a highly readable account oi the interplay between theory and practice in the development of modern financial economics.