Stochastic Dominance, Pareto Optimality, and Equilibrium Asset Pricing

Abstract

This paper introduces the concept of a factor subspace in competitive equilibrium asset pricing. A factor subspace contains the market portfolio and is such that every marketed contingent claim is second-order stochastically dominated by a claim from the factor subspace. Conditions are given for the existence of equilibrium, and it is shown how APT and CAPM can be interpreted in the framework of the paper. If sufficiently many call options on the market portfolio are traded, then the space spanned by these options can be used as the factor subspace.