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 PORTFOLIO
SELECTION
AND
ASSET PRICING
This page intentionally left blank
 PORTFOLIO
SELECTION
AND
ASSET PRICING
MODELS OF FINANCIAL ECONOMICS AND
THEIR APPLICATIONS IN INVESTING

JAMIL BAZ
HELEN GUO
EROL HAKANOGLU

New York Chicago San Francisco Athens London

Madrid Mexico City Milan New Delhi
Singapore Sydney Toronto
Copyright © 2022 by Jamil Baz, Helen Guo, and Erol Hakanoglu. All rights reserved. Except as per-
mitted under the United States Copyright Act of 1976, no part of this publication may be reproduced
or distributed in any form or by any means, or stored in a database or retrieval system, without the
prior written permission of the publisher.

ISBN: 978-1-26-427016-3
MHID: 1-26-427016-X

The material in this eBook also appears in the print version of this title: ISBN: 978-1-26-427015-6,
MHID: 1-26-427015-1.

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—From a Declaration of Principles Jointly Adopted by a Committee of the
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 To Zeina, Maurice, Elena, and Alexandra,
with love and admiration.
J.B.

To Yazhen and Zhijun who gave me life

and Adam and Daniel who gave my life new meaning.
H.G.

To Silvia, Aviva, and Orli, with all my love.

E.H.
This page intentionally left blank
 Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix

Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii

PART I
Mathematical Foundations
1 Functional Analysis in Real Vector Spaces . . . . . . . . . . . . . . . . . . . . . .3

2 Optimization in Discrete Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25

3 Optimization in Continuous Time . . . . . . . . . . . . . . . . . . . . . . . . . .35

4 Utility Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45

5 Uncertainty: Basics of Probability and Statistics . . . . . . . . . . . . . . . . .51

6 Uncertainty: Stochastic Processes and Calculus . . . . . . . . . . . . . . . . .69

PART II
Portfolio Models
7 Single-Period and Continuous-Time Portfolio Choice . . . . . . . . . . . .97

8 An Example of Asset Allocation for a Sovereign . . . . . . . . . . . . . . . .135

9 Liability-Driven Asset Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . .145

vii
viii • Contents

PART III
Asset Pricing
10 Equilibrium Asset Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .161

11 Factor Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .187

12 Derivatives Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .199

13 Interest Rate Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .237

14 Risk Premia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .263

PART IV
Asset Allocation in Practice
15 Motivations for Robust Asset Allocation . . . . . . . . . . . . . . . . . . . . .297

16 Risk Budgeting Approach to Asset Allocation . . . . . . . . . . . . . . . . .303

17 Black–Litterman Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .315

18 Shrinkage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .329

19 Robust Optimizers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .345

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .367

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393
 Introduction

Portfolio selection and asset pricing are the centerpieces of finance. If there
is any hope to have fundamental theorems in financial economics, these two
topics arguably provide the best opportunity. Yet, because financial markets
constantly involve complex feedback between actors and models, the size of the
gap between the fundamental results of mathematics and physics and those of
finance is humbling.
How do we solve quantitative problems? In the realm of mathematics, we
formulate rigorous theorems and prove their validity with little left to approx-
imation. Chemistry and physics are built on fundamental laws and theorems
that are amenable to rigorous experimental verification, such as Newton’s laws of
motion and thermodynamics, Maxwell’s equations of electricity and magnetism,
and Einstein’s general relativity theory.
When we move away from pure mathematics, in order to formulate and
verify our understanding of nature, we rely on models of reality, built either
physically or as thought experiments. If mathematics lies at one end of the spec-
trum of sciences, economics and finance belong at the other end. In the latter,
the models need to account for quirky human behavior, which at times does not
even obey basic building blocks of logic such as transitivity.
Compared with mathematics or the physical sciences, the fundamental laws
of financial economics are just a valiant attempt to make sense of messy data and
behaviors. We try hard to do the best we can. After all, instead of universal con-
stants such as π, Avogadro’s number N, gravitational constant g, speed of light c,
and Planck’s constant h, we must deal with the short-term interest rate set by a
subordinate deity who runs the Federal Reserve.

ix
x • Introduction

Jorge Luis Borges, a brilliant and sometimes delirious writer of the twentieth
century, imagined a realm where the science of map making becomes so precise
that only a one-to-one scale is acceptable—acceptable but wholly impractical,
even if possible.1 In this book, we will settle for less than perfect models of port-
folios and assets and their interconnections.

Asset Pricing
Asset pricing is about connecting payoffs in future states of the world with
the right discount rate. Most interesting pricing problems involve uncertainty
around these states of the world and a stochastic discount rate.
In pricing assets, general equilibrium models and consumption-based models
help us determine prices for assets based on fundamental risk factors in the econ-
omy, such as the capital asset pricing model and the family of models derived
from it. Financial markets abound with observable prices for a plethora of assets.
Some assets are more easily valued relative to their observably priced reference
assets. The Black–Scholes–Merton option pricing model exemplifies these type
of valuation methodologies.

Portfolio Selection
From the management of pension funds to personal finances, from corporate
capital structure management to sovereign asset-liability management, from
insurance company asset portfolio management to endowment and sovereign
wealth fund management, literally billions of people around the globe directly
or indirectly depend on portfolio selection. We will attempt to present the fun-
damentals of portfolio selection that evolved into an impressive body of work
over the past seven decades.
Once the groundwork is laid, we will discuss portfolio selection theories
in depth, studying their interconnections and differences. The efficacy of any
model hinges on its theoretical construct and on the realism and accuracy of its
inputs. We focus on statistical approaches that help us attain that realism and
accuracy, such as robust estimation. In discussing implementation issues, we

1 J. L. Borges, “On Exactitude in Science,” in A Universal History of Infamy. New York: Penguin, 1975.
 Introduction • xi

will describe the leading methodologies in the field and differentiate between
them critically.

...

The finance literature is home to a vast number of texts on asset pricing and
portfolio selection. The focus of these texts is mostly on only one of the two;
in only a few cases are both considered together. Our aim is to take the latter
approach while demonstrating pathways from one to the other and vice versa
and while treating theory and applications holistically.
You should be familiar with the language of mathematics to get the best
out of this book. We assume competence in the fundamentals of multivariate
calculus, differential equations, linear algebra, probability, and statistics. Having
said that, Part I of this text is dedicated to a review and extension of these fun-
damentals. If you are familiar with relevant topics, you can skim through Part I
and jump to Part II without missing the essence of this book.
The intended audience of this text includes advanced undergraduates in
mathematics, economics, finance, and engineering; MBA students with a
quantitative bent; students in financial engineering master’s programs; doctoral
students in mathematical economics, finance, and financial engineering; and
practitioners in the financial industry interested in quantitative finance and
economics.
This book is divided in four parts. Even though they could be appreciated
independently, we believe that going through each individually is most benefi-
cial. We have written the chapters so that they are as self-contained as practically
possible. In this spirit, each chapter has a summary of contents up front. We
outline the four parts as follows:
In Part I, we lay out the mathematical foundations of the theories and prac-
tical applications that make up the rest of the text. The idea is to provide a
compact introduction to many concepts of mathematical analysis that lurk in
the background, sometimes hardly visible yet fundamental to the development
of modern finance. We rely on well-known texts in summarizing definitions,
theorems, and their proofs, which we believe promote a thorough understand-
ing of what follows.
In Part II, we cover portfolio selection models. The fundamental concepts and
theories are laid out in detail in single-period and continuous-time settings. In
what we believe is an interestingly novel treatment, the last section of Chapter 7
xii • Introduction

is dedicated to analogies and correspondences between the concepts and theories

discussed in earlier chapters.
In Part III, we describe the fundamental theories and concepts behind asset
pricing, starting with equilibrium models and moving on to factor models
before delving into derivatives pricing from the simple to the exotic. In this
part, we also focus on interest-rate models and derivatives pricing associated
with fixed-income markets. The part concludes with the intricate concept of
risk premia.
Part IV is where we move to the practice of portfolio selection. Despite the
intuitive appeal of many quantitative models, over the years we have observed
that practitioners are often reluctant to apply them in practice. In this part, we
analyze the key issues methodically and offer solutions that have had a good
track record in practice.
It’s important in any book to appeal to readers. Italo Calvino, a true Italian
master of literature who embodied the word simpatico, was asked to deliver the
1985 Norton Lectures at Harvard. The honor led to the writing of his ultimate
book, Six Memos for the Next Millennium, a compendium of six lectures, each
addressing a quintessential quality for a writer to impart on a text: lightness,
quickness, exactitude, visibility, multiplicity, and consistency.2 We tried to abide
by all six, yet it is the first lecture from the sextet that we took to heart as we tried
to lighten the weight from the narrative as much as we could.

2 I. Calvino, Six Memos for the New Millennium. Boston: Harvard University Press, 1988. Italo Calvino
passed away just before completing the final “memo” and could not actually deliver the much-anticipated
lectures in September 1985.
 Acknowledgments

We start by extending special thanks to Emmanuel Roman for his friendship.

The coauthors would not have met without his intercession, and this project
owes much to his encouragement and intelligent guidance.
Robert Merton had a profound influence on the authors and hence on this
manuscript. His work was foundational in every aspect of asset pricing, deriva-
tives, and portfolio theory. We are, as ever, in his debt.
We are beholden to many people who have helped us in our intellectual for-
mation, our professional growth, and our life journey. We thank them from our
hearts and minds.
First are our teachers, some of whom have left us: Takeshi Amemiya,
Kenneth Arrow, Fischer Black, Michael Boskin, Roger Brockett, Robert
Dorfman, Robert Ferrandier, Harry Gregor, Yu-Chi Ho, Lawrence Lau, John
Lintner, Andrew Lo, Franco Modigliani, Peter Rogers, and Jean-Luc Vila.
Then there are our colleagues past and present: Ramasastry Ambarish, Armen
Avanessians, Driss Ben Brahim, Jonathan Berk, Thomas Brennan, Eric Briys, Terry
Burnham, Jean-Paul Calamaro, George Chacko, Josh Davis, Sanjiv Das, François
Degeorge, Ludovic Feuillet, Normane Gillmann, Nick Granger, Mahmoud
Hajo, Campbell Harvey, Lloyd Han, Dan Ivascyn, Soraya Kazziha, Sean Klein,
Vincent Koen, Sudi Mariappa, René Martel, Ravi Mattu, Scott McDermott,
Nikola Miljkovic, Ben Mills, Arun Muralidhar, Vasant Naik, Michael Pascutti,
Brian Pinto,Vlad Putyatin, Scott Pinkus, German Ramirez, Steve Sapra, Lester
Seigel, Nassim Taleb, Jason Tilroe, Jerry Tsai, Emmin Shung, Sadek Wahba, Larry
Wieseneck, Richard Witten, Francis Yared, Ziqi Zhang, and Wentao Zhao.

xiii
xiv • Acknowledgments

We cannot stop thanking our colleague Zhifeng Wang for an incredible

amount of excellent work that went into this book throughout the process,
improving its quality significantly. Our colleague Tarek Nassar pored through
the manuscript with diligence and provided us with excellent suggestions. As
such, they both have to take responsibility for all remaining mistakes.
We also thank our colleague Tony Crescenzi for introducing us to McGraw Hill
and Stephen Isaacs and Judith Newlin for being the best editors any author could
ever hope to have on their side. Our thanks also go to Patricia Wallenburg from
TypeWriting who has done a terrific job in the many aspects of the production of
this book.
We are immensely thankful to our families for all the love and support they
have given us throughout our lives and during this project in particular.
This book came together in a most difficult year. The pandemic took a lot from
all of us. We consider ourselves lucky to have worked together so harmoniously
while getting to know each other more throughout the process. We acknowledge
the tremendous support we found in each other throughout our adventure. In
particular, we shared movies as a means of sustenance. Films by Robert Bresson,
Carl Dreyer, Krzysztof Kieślowski, Yasujirō Ozu, Andrei Tarkovsky, and Béla
Tarr gave us ample food for thought, and discussing them helped keep our spir-
its up. Also, we owe film directors Ernst Lubitsch and Billy Wilder many gifts of
laughter. We marveled at the wit and lightness of these emigrants from central
Europe who understood so much about their time and society.
 PORTFOLIO
SELECTION
AND
ASSET PRICING
This page intentionally left blank
 PART I

Mathematical
Foundations
This page intentionally left blank
 1
Functional Analysis in
Real Vector Spaces

Summary
The primary mathematical idea behind portfolio selection theory and
practice is optimization. Functional analysis, which is the study of vector
spaces in finite and infinite dimensions using concepts and insights from
linear algebra, analysis, and geometry, serves as the mathematical basis for
theories and optimization models of portfolio selection.1 Representation,
projection, duality, extension, and separating-hyperplane theorems form
the analytic basis for a significant portion of resource and asset allocation,
planning, optimal control, approximation, and estimation problems in
financial economics. Optimization theory could be developed in finite-
dimensional Euclidean space using elementary geometric concepts and
intuitions. As the complexity of the underlying problems increases, exten-
sion to infinite-dimensional spaces becomes indispensable.

1 The following are standard symbolic abbreviations used throughout this part: ∀ is “for all”; ∈ is “in”;
∋ is “such that”; ∃ is “there exists”; ≡ is “defined as”; ≠ is “not equal to”; ∄ is “there does not exist”; ∅ is
“empty set”; ∩ is “intersection”; ∪ is “union”; ⊂ is “subset”;  is “implies”; ↔ is “if and only if ”; and ■
is “quod erat demonstrandum” or “QED,” which means “that which has been proven.”

3
4 • Portfolio Selection and Asset Pricing

Such underlying complexity is the reason for going through the trouble
of introducing Hilbert spaces, for example. In the projection theorem,
the simple geometric concept in our three-dimensional Euclidean space—
that the shortest distance from a point to a plane is the perpendicular—is
extended to spaces of higher and infinite dimensions by moving the con-
cept to Hilbert space. There are numerous applications of these extensions
to financial economics problems such as least squares and other estimation
problems. The same is true of the separation theorems that are fundamen-
tal to capital asset pricing.
If you are familiar with basic functional analysis or are not interested in
a more mathematical treatment, you could skim through this chapter or
skip it without loss of generality. We draw heavily from excellent textbooks
on these topics, including Bartle (1966), Bartle and Sherbert (2010), Lang
(1969), Lasdon (1970), Luenberger (1969), and Rudin (1987, 1991).

1.1 Vector Spaces

1.1.1 Basic Properties and Definitions
A vector space V is a set of elements called vectors together with the operations of
addition and scalar multiplication. If x, y, z are vectors in V and a, b are scalars,
the following axioms would be satisfied by the set V and the two operations:

Commutative law: x+y=y+x

Associative law: (x + y) + z = x + (y + z)
– – –
Null vector 0 (addition)2: x + 0 = x, where 0 ∈ V
–
Scalar multiplications 0 and 1: 0x = 0, 1x = x
Distributive law I: a(x + y) = ax + ay
Distributive law II: (a + b)x = ax + bx
Associative law: (ab)x = a(bx)

For every x ∈ V, there exists an element -x ∈ V called the additive inverse of x

–
such that x + (-x) = 0.

–
2 We will suppress the vector notation 0 to describe the null vector when the context is clear.
 Functional Analysis in Real Vector Spaces • 5

In any vector space, the following properties hold:

x+ y= x+ z⇒ y= z
ax = ay, a ≠ 0 ⇒ x = y
ax = bx, x ≠ 0 ⇒ a = b
(a - b)x = ax - bx
a(x - y) = ax - ay
– –
a0 = 0

1.1.2 Simple Examples of Vector Spaces

Example 1: Given the set of real numbers ℜ and the applicability of the stan-
dard definition of addition, as well as that of multiplication by a scalar number,
and the null vector equaling the real number zero, the set of real numbers (also
known as the real line) is a one-dimensional vector space.

Example 2: We extend the first example into n-dimensional space by letting

V = ℜn be the set of sequences or n-tuples of real numbers. With x = (x1, x2, x3, …,
xn) and y = (y1, y2 , y3, …, yn ) being n-tuples, we define x + y = (x1 + y1, x2 +
y2, …, xn + yn ). Let a ∈ ℜ and aX = (ax1, ax2, …, axn). We can see that the
axioms for a vector space are satisfied.

Example 3: If we let V be the nonempty set of all real-valued functions and let
f and g be such functions, we may define f + g and af in the standard way to see
that V is a vector space.

Example 4: Let us take the closed interval [a,b] ⊆ ℜ. The collection of all real-
valued functions forms a vector space. Let x = y if x(t) = y(t) for all t ∈ [a,b]. The
–
null vector 0 is a function that is identically zero in the closed interval. If x, y are
vectors in the space and c is a real scalar, (x + y) (t) = x(t) + y(t) and (cx)(t) = cx(t).
It can easily be seen that these are continuous functions. This space is the vector
space of real-valued continuous functions in the closed interval [a, b].

1.1.3 Cartesian Products, Subspaces, and Combinations

of Vector Spaces
A set of vector spaces could be combined to form a larger one. If V, W are vec-
tor spaces, the Cartesian product of V and W, V × W, consists of ordered pairs
6 • Portfolio Selection and Asset Pricing

(v, w) with v ∈ V and w ∈ W. The following addition and scalar multiplication

properties hold in V × W:

(v1,w1) + (v2, w2) = (v1 + v2, w1 + w2)

a(v,w) = (av, aw)

Clearly this can be extended to the product of n vector spaces V1, V2, V3, …, Vn.
Further we denote the product of a vector space with itself n times as V n.
A subset of vector space V that is not empty is called a subspace S of V if every
vector x, y ∈ S ⇒ ax + by ∈ S for any scalars a, b. The sum of two subsets S1 and
S2 is S1 + S2 and consists of all vectors s1 + s2, s1 ∈ S1, s2 ∈ S2.
It can be easily proved that if S1, S2 are subspaces of vector space V, their
intersection S1 ∩ S2 is a subspace of V, as well as that their sum S1 + S2
is a subspace of V.3 In a vector space, a linear combination of the vectors
n
x1, x2, x3, …, xn with scalars a1, a2, a3, …, an can be written as ∑a x i i . If S is a
i =1
subspace of a vector space V, the set {S} is called the subspace generated by S con-
sisting of all vectors in V that are linear combinations of vectors in S. A simple
way to think of subspaces is the notion of a plane or line through the origin. The
translation of a subspace is the generalization of a plane or line and is referred to
as a linear variety (or a linear manifold or an affine subspace). For a subspace S,
a linear variety can be written as S′ = x0 + S, where x0 ∈ S. The subspace S is
unique, yet any vector in S′ could be taken as x0. The linear variety generated by
a nonempty subspace S of vector space V could be defined as the intersection of
all linear varieties in V contained in S.

1.1.4 Convexity
A set C in a linear vector space is convex if given x1, x2 ∈ C, all points ax1 +
(1 - a) x2 ∈ C, where 0 ≤ a ≤ 1. If C1, C 2 are convex sets in a vector space, then

aC = {x: x = ac, c ∈ C}

3 S1 ∩ S2 contains the null vector because it is contained in both spaces themselves; hence the intersec-
tion is not empty. If v1, v2 ∈ S1 ∩ S2, they are both in S1, S2. For any scalars a,b, the vector av1 + bv2 is
contained in both S1 and S2 because they are subspaces of V. Therefore, av1 + bv2 ∈ S1 ∩ S2.
 Functional Analysis in Real Vector Spaces • 7

is convex for any scalar a, and

C1 + C2

is convex. For an arbitrary collection of convex sets, their intersection is also

convex.4

1.1.5 Linear Independence

It is trivial to show that the necessary and sufficient condition for the set of vec-
n

tors xi, i = 1, 2, …, n to be linearly independent is that ∑ ai xi = 0 ⇒ ai = 0

i =1
for all i = 1, 2, …, n. This implies that a vector expressed as a linear combination
of linearly independent vectors can be expressed uniquely so. In other words,
n n

if vectors xi ∀i are linearly independent, and if ∑ ai xi = ∑ bi xi, then

i =1 i =1
ai = bi ∀i.5

1.2 Metric Spaces

A metric is a function that defines the distance between any two members
or points of a set called a metric space. Formally, a metric on a set X is a function
d: X × X → ℜ with the following properties:

Positivity: d(x, y) ≥ 0, ∀ x, y ∈ X
Definiteness: d(x, y) = 0  x = y
Symmetry: d(x, y) = d( y, x), ∀ x, y ∈ X
Triangle inequality: d(x, y) ≤ d(x, z) + d(z, y), ∀ x, y, z ∈ X

A metric space (X, d ) is a set X together with a metric d on X.

Example 1: Normal Metric

d(x, y) ≡ |x - y|, ∀ x, y ∈ ℜ

4 The proof is trivial and left as an exercise for the reader.

5 The reader is encouraged to prove these simple propositions as an exercise.
8 • Portfolio Selection and Asset Pricing

Example 2: Euclidean Metric

If points x ≡ (x1, x2) and y ≡ (y1, y2) ∈ ℜ2, then d(x, y) = ( x1 - y1 )2 + ( x 2 - y 2 )2 .

Example 3: Maximum Metric

For the points x, y in Example 2, d(x, y) ≡ max(|x1 - y1|, | x2 - y2|).

Example 4: Discrete Metric

If X is a nonempty set and x, y ∈ X, then

d(x, y) = 0, if x = y, and d(x, y) = 1, if x ≠ y

Let us show that d(x, y) is a metric. Again, the first three properties being trivially
satisfied, we show how the fourth, the triangle inequality, holds:

When x = y, d(x, y) = 0 ≤ d(x, z) + d(z, y).

When x ≠ y, d(x, y) = 1 = {d(x, z) or d(z, y)} ≤ d(x, z) + d(z, y).

1.3 Open and Closed Sets

For the metric space (X, d ), we define an open ϵ-ball of radius ϵ > 0 centered
at x as

Bϵ(x) = { y ∈ X | d(x, y)< ϵ}

A point w ∈ A ⊆ X is called an interior point of A if ∃ an ϵ > 0 such that all

points x satisfying d(x, w) < ϵ are in A. The collection of all interior points of
A is the interior of A.
Set A ⊆ X is called an open set if ∀x ∈ A, ∃ an open ϵ-ball with Bϵ(x) ⊆ A.
x ∈ X is called a boundary or closure point of A if ∀ϵ > 0, Bϵ(x) ∩ A ≠ ∅ and Bϵ(x) ∩
Ac ≠ ∅, where Ac ≡ complement of set A ⊆ X. The union of A and the collection
of all boundary points of A is called the closure of A and is denoted by A . Set A is
called a closed set if Ac is open. A is open  A ∩ (all boundary points of A) = ∅.

Proposition 1: The complement of an open set is closed; the complement of a

closed set is open.

1.4 Convergence and Cauchy Sequences

An infinite sequence is an ordered set of points inside the metric space (X, d )
denoted as {x1, x2, …} ≡ {xn}n∈N . It is called convergent if there is a limit point
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LONG ago, soon after the Children of Israel came out of Egypt, they asked Aaron to make
a Golden Calf for them to worship, which could be carried in front of them, and would, they
hoped, lead them into the Promised Land. But we know how dreadfully they sinned in this.

And five hundred years after that, Jeroboam, King of Israel, made two Golden Calves, and
built two altars, one in Dan at the North of Palestine, and the other in Bethel at the South
of his Kingdom.

He told the people of Israel that it was too far for them to go to worship at Jerusalem,
three times in the year, and that they could go instead to worship his Golden Calf, and
could offer sacrifices upon the altars he had built.

Now God had told the Jews that Jerusalem was the place He had appointed for Worship;
and also that only God's Priests, the sons of Aaron, were to offer either Sacrifices or
Incense to Him.

One day, when King Jeroboam was himself offering incense on the altar he had made in
Bethel, a Prophet of the Lord was sent to him with a message from God.

And this was the message—That one day, on this; very altar, the priests whom Jeroboam
had made from the lowest of the people, should be offered, and their bones should be
burnt upon this altar.

God gave a Sign, by which King Jeroboam should know that the Prophet's words were
true, and that he had been sent by God.

This was the Sign. This altar of Jeroboam's should be rent—torn in pieces—and the ashes
should be scattered on the ground.

King Jeroboam was very angry at the message, and he tried to seize the Prophet, but his
hand dried up, and he could not use it.

And the Sign came to pass at once, for the altar fell to pieces and the ashes were
scattered.

Jeroboam was very frightened, and begged the Prophet to ask the Lord to restore his
hand.

And the Prophet did; and Jeroboam's hand was made quite well again.
 A Prophet of the Lord was sent to him with a message from God.

Then the King pressed the Prophet to come in to refresh himself, and to receive a reward.

But the Prophet answered that the Lord had strictly forbidden him to eat bread or drink
water in that place. So he turned away, to go back by another road, as the Lord
commanded him.

But now a great temptation met him.

For as the Prophet was turning away from Bethel, an old Prophet who lived there, thought
he would ask him to come back and rest at his house. He had heard how the Prophet had
cried against the Altar, and he longed to hear all about it.

But the Prophet again explained that the Lord had forbidden him to eat and drink in that
place.

Then the Old Prophet lied to him, and said that an Angel had told him he was to ask him
home to refresh him.

So the Prophet listened to his fellow-prophet, instead of obeying God, and he turned back
and went in, and ate and drank.

But when he had finished the meal, the Word of the Lord came to the Old Prophet, with a
terrible message to the disobedient man.

"Forasmuch as thou hast disobeyed the Lord, and hast not kept the Commandment which
the Lord thy God commanded thee . . . thy carcase shall not come to be buried in the
sepulchre of thy fathers."

So the Old Prophet gave the message, and he sorrowfully saddled the ass of the
disobedient Prophet, and sent him forth on his return journey. But very soon a lion met
him in the way, and slew him; and his body lay by the roadside, and the lion and the ass
stood by, but the lion did not eat either of them.

By and by people passed that way, and they hastened to the city to tell what they had
seen.

THE DISOBEDIENT PROPHET.

Then the Old Prophet told his sons to saddle his ass, and he hurried along the road until he
came to the spot where the dead Prophet lay. And he found all as he had been told, and
saw that the Lord had not allowed the lion to touch the dead man, or the ass.

Then the old man laid the body of the Prophet on his ass, and brought him back to bury
him in his own grave; and he mourned bitterly for him, for he knew he had tempted him,
and had been the cause of his death.

He charged his sons, that when he came to die, they were to bury him in the same grave
with the Prophet; and he added a solemn assurance that the words of God which the
Prophet had uttered against King Jeroboam's altar in Bethel, and against the other
idolatrous places which he had built, should surely come to pass.
All this was literally fulfilled three hundred years after, in the reign of Josiah, the good
young King. We read the account of it in three verses in 2 Kings 23.15-18.

But King Jeroboam, knowing of this Prophecy, remembering as he must that his withered
hand had been healed by God, did not set his heart to seek God and to find forgiveness.

He went on in his evil ways all his life, until at length we read in the Bible the name by
which he was known after his death, "Jeroboam, the son of Nebat, who made Israel to
sin."

This long ago story speaks an ever-living lesson.

The God who commands will enable us to obey. Let us seek Him with all our hearts: let us
learn His will in the Bible, and then the promise to each one of us will come true—

"To him that soweth righteousness, shall be a sure reward."

XXVI. THE LORD ANSWERS ELIJAH BY FIRE

1 KINGS 18, 19

THEN after a long time, the word of the Lord came to Elijah in the third year of the famine,
saying to him, "Go, show thyself to Ahab; and I will send rain upon the earth."

So Elijah went back from Zarephath, and came down to Samaria to show himself to Ahab;
and the famine was very sore there.

Ahab had a trusted servant called Obadiah, who was governor of his house; and this man
"feared the Lord greatly."

That meant, he did that which would please God, and earnestly obeyed Him in all things.
Once, when the wicked queen, Jezebel, tried to kill all the Prophets of the Lord, Obadiah
took fifty of them and hid them in a cave, and fed them with bread and water, and so
saved their lives.

So because the famine was very terrible in Samaria, Ahab called Obadiah, and told him
that they would both go out into the country with the horses and mules and find all the
brooks and streams that were left, where a little grass might be growing, to save the
horses alive.

Ahab went one way and Obadiah another, and as Obadiah was seeking for water, he met
Elijah, who was on his way to Ahab, as the Lord had told him. When Obadiah saw him, he
bowed himself to the earth before God's Prophet; and then Elijah said, "Go and tell thy
lord that Elijah is here."

Obadiah hesitated very much to carry this message, as he was afraid that the Spirit of the
Lord might carry Elijah away, so that he could not be found. He reminded Elijah that he
had "feared the Lord" since he was a child, but that Ahab would certainly slay him if he
carried such a message to him as that!

Then Elijah promised him, that he would surely show himself to Ahab that very day.

So Obadiah went and told Ahab, and the king came out to meet Elijah.

Then Ahab said to him, "Art thou he that troubleth Israel?"

And Elijah answered, "It is thou and thy father's house that have troubled Israel, because
ye have forsaken the Lord's commandments and have worshipped Baal!"

Then he told Ahab to gather together the people, and all the four hundred and fifty
prophets of Baal, and the four hundred prophets of the grove, who sat down daily at
Jezebel's table, and to take them to Mount Carmel, and meet him there.

So a number of the people, and all the prophets of Baal, came together to Mount Carmel.

And Elijah came to the people, and he said, "How long do you mean to halt between two
opinions? If the LORD be God, follow Him! but if Baal, then follow him."
 Then the fire of the Lord fell, and consumed the burnt sacrifice.

And the people did not answer a word.

Then Elijah said, "I am the only Prophet of the Lord, and Baal's prophets are four hundred
and fifty. Let them therefore give us two bullocks, and let them choose one for themselves
and slay it, and dress it, and put it on the altar, with no fire under."

"And I will slay and dress the other bullock, and put it on the altar, and put no fire under.
And the God that answereth by fire, let Him be God!"

So the priests of Baal took their bullock and did as Elijah had said; and they cried unto the
name of their god from morning until noon, saying, "O Baal, hear us!"

But there was no voice nor any that answered. And they leaped upon the Altar which was
made.

Then Elijah mocked them, and told them to cry aloud, as their god was talking, or on a
journey, or asleep, and must be awaked! And they cried aloud, and cut themselves with
knives. And thus they went on till the time of the evening sacrifice. But there was neither
voice, nor any to answer, nor any that regarded.

Then Elijah said to all the people, "Come near unto me."
And he repaired the Altar of the Lord that was broken down, and built it up with twelve
stones for the twelve tribes of Israel; and he cut a deep trench round the Altar, and put the
wood in order, and cut the bullock in pieces and laid him on the wood.

Then he told the men to fill four barrels with water, and to pour it on the burnt sacrifice
and on the wood; and this he ordered to be done three times, so that the water ran all
about the Altar; and he filled the trench with water.

Elijah knew what his God, Jehovah, was going to do, and what a glorious ending there
would be!

So at the time of the evening sacrifice Elijah drew near to the Altar and prayed: and he
said, "Lord God of Abraham, Isaac, and of Israel, let it be known this day that Thou art
God . . . and that I am Thy servant, and that I have done all these things at Thy word."

"Then the fire of the Lord fell, and consumed the burnt sacrifice, and the wood, and the
stones, and the dust, and licked up the water that was in the trench."

"And when all the people saw it, they fell on their faces: and they said, The Lord, He is the
God; the Lord, He is the God!"

"And Elijah said unto them, Take the prophets of Baal, let not one of them escape! And
they took them and brought them down to the brook Kishon." And they were all killed. The
children of Israel had acknowledged their God at last!

Then Elijah turned to Ahab the king, who, like the people, had cast himself in awe and
reverence upon the ground. And he said to Ahab, "Arise, and eat, for there is a sound of
abundance of rain!"

XXVII. JOSHUA'S COURAGE

JOSHUA 1.1-18
After the death of Moses, when the Lord, Himself, had buried His faithful servant, the Lord
came to Joshua and told him that he was to be the one who should lead the Children of
Israel into the Promised Land.

We hear of Joshua many times as we read the life of Moses.

He shared the glorious triumph when the Children of Israel were brought out of Egypt; and
soon after that, Moses chose Joshua to lead the people to fight against Amalek.

Next we hear of him as the trusted servant (or minister, as it is called in the Bible), who
went up with Moses to the Mountain called Sinai, when Moses received the Ten
Commandments from God.

Joshua did not go all the way with Moses, but waited somewhere on the mountain till
Moses should come down from talking with the Holy God.

And as they went down again, it was he who saw the Children of Israel worshipping the
golden calf below.

Next, Joshua was one of the twelve spies who were sent to search out the Land; and you
will doubtless remember that ten of these spies brought a bad report, and only two of
them, Caleb and Joshua, brought a good report.

We see Joshua's splendid courage through all these circumstances.

He trusted God with all his heart, and the Lord was his sure Refuge and constant Helper.

And it is very wonderful to remember, that among the Israelitish men who came out of
Egypt and wandered in the Wilderness for forty years, the only two who entered the
Promised Land were Caleb and Joshua, the two faithful spies! All the rest of the Israelitish
men who came out of Egypt died in the Wilderness for their disobedience, and only their
children entered the Promised Land.

It is a very solemn thing to be disobedient to God.

So as I said, the Lord came and spoke to Joshua, and told him he was to lead the people
into the Land of Canaan.

One day soon after this, Joshua sent two spies to bring back word what kind of a land it
was which he had to conquer. When they came to Jericho they came to the house of a
woman named Rahab, and lodged there.

But the King of Jericho heard of it, and sent to Rahab to give up the men to be killed.

But Rahab had heard of all the wonders that the Lord had done for His people, in bringing
them out of Egypt; how He had dried the Red Sea for the people to pass over, and of other
great victories; and instead of giving up those two Israelites to the King of Jericho, she
quickly hid them on the flat roof of her house, under a lot of flax stalks, and when the
messengers from the King came, they did not find them, and Rahab told the King's soldiers
that they had better seek the men on the road to Jordan, as quickly as they could.

So the King's men went away to look for them, and the City gates were shut, and all was
quiet again.
Then Rahab went up to the roof and told the spies that they must escape at once; and she
begged them to promise her faithfully, that when God had given them the Victory, which
she was sure He would do, that they would save her life.

So the men told her to bind a scarlet cord in her window which was on the outer wall, that
they might recognise the place; and she let them down in the night through this window,
and they got away.

All this the men faithfully carried out, and we read in the 11th of Hebrews, written nearly
1500 years after, that it was by faith that Rahab saved the spies, and by this saved her
own life too.

God loves for us to have faith in Him! And it was this faith in God which made Joshua
courageous all his life.

So Joshua and the people crossed the Jordan and entered into the Land, and came to
Jericho; and one day when Joshua was standing viewing the strength of the City, suddenly
he found Someone by him with a drawn sword in His hand.

So Joshua went to him at once, and asked "if he were going to fight for the Israelites or for
their enemies?"

And the Stranger said: "Nay, but as Captain of the Lord's Host am I now come."

Then Joshua fell on his face and worshipped, for he knew that this was the Lord Who was
speaking to him, and Who had taken the Supreme Command!

No wonder that when Joshua was old, and knew he was going to die, that he called all the
Israelites together, and rehearsed all the wonderful doings of the Lord; and that he begged
them with all his strength to serve and obey the Lord with all their hearts.

CHOOSE YE THIS DAY.

And Joshua set up a great Stone to be a Witness to them, that they had promised to love
and obey God; and he said the Stone would remind them, lest they should forget their
promise and turn back from serving God.

So the Israelites promised to be faithful, and while the elders who outlived Joshua were
alive, they did follow the Lord. But after a time they began to forget, and this brought a
great deal of sorrow upon them.

Perhaps you think within yourselves, "I should like to obey God, and follow Him! I wonder
how I could begin?"

Think of Joshua. He followed the Lord wholly—which meant with all his heart. That was the
first thing. So you can pray, "Take my heart, Lord Jesus, and help me to follow Thee!"

Then he obeyed whatever God told him to do. And whatever Command you find in the
Bible, as shewing you God's Will—do it!
 XXVIII. THE FIERY FURNACE

NEBUCHADNEZZAR'S dream of the Great Image had been explained to him by Daniel and
his three companions; but the king soon forgot the wonderful interpretation which God had
sent him, containing such an unfolding of the future which, in due time, has come to pass.

One great dynasty after another—Babylon, the Medes and Persians, Greece, and Rome,
have arisen and passed away, till at length, up to now, only the Feet of the Vision of the
Great Image wait to be accomplished.

And when history shows us that all has been fulfilled except the Feet of iron and clay, we
know that we must be very near to the coming of the Wonderful Stone, which by and by is
to fill the whole earth.

You will some of you understand what I mean when I say that this is Symbolical language.
That means, that it is a picture of Heavenly Things which is to teach us about earthly
things.

That Stone is a symbol of our Lord Jesus Christ when He comes back from Heaven to reign
over the whole earth. We read in the seventh chapter of Daniel these words: "I saw in the
night Visions, and behold one like the Son of man came with the clouds of Heaven . . . and
there was given Him dominion and glory and a kingdom, that all people, nations and
languages should serve Him: His dominion is an everlasting dominion which shall not pass
away, and His kingdom that which shall not be destroyed."

King Nebuchadnezzar remembered the part of his dream of the Great Image that applied
to himself—he knew he was the head of gold.

This probably made him think of making a real image, and setting it up in the plain of Dura
for every one to worship.

So the heralds went forth and told the people that at the sound of any musical instrument
they were instantly to fall down and worship the Golden Image that Nebuchadnezzar had
set up.

And in order to force compliance, this mighty king made a terrible threat, that whoever
refused to worship it, should be cast into a burning fiery furnace.
 The most mighty men in his army were to bind Shadrach, Meshach, and Abednego.

But the Chaldeans, who were very jealous that Shadrach, Meshach, and Abednego had
been set up over the affairs of the kingdom, came near and told Nebuchadnezzar that the
Jews refused to bow down and worship the Golden Image which he had set up.

Then Nebuchadnezzar in his rage and fury commanded to bring Shadrach, Meshach, and
Abednego before him.

So he asked them: "Is it true that you will not worship the Golden Image which I have set
up? If you are ready to worship, well; but if not, you shall be cast the same hour into the
midst of the fiery furnace. And who is that God that shall deliver you out of my hand?"

But the three young men were strong in the might of their God, and they answered—

"We are not careful to answer thee in this matter. If it be so, our God whom we serve is
able to deliver us from the burning fiery furnace, and He will deliver us out of thine hand,
O King. But if not, be it known unto thee, O King, that we will not serve thy gods, nor
worship the Golden Image which thou hast set up."

Then Nebuchadnezzar was full of fury, and he ordered that they should heat the furnace
seven times hotter than usual, and that the most mighty men in his army were to bind
Shadrach, Meshach, and Abednego, and to cast them into the fiery furnace.

And because the king's command was urgent and the furnace exceeding hot, the flames
killed the men who had to throw Shadrach, Meshach, and Abednego into the fire.

And the three young men fell down, bound, into the midst of the furnace.

The king was watching the dreadful scene; but suddenly a great fear shook him, and he
turned to his counsellors with the question, "Did not we cast three men, bound, into the
fire?"
And his counsellors said that it was true, they had.

Then King Nebuchadnezzar said: "Lo! I see four men, loose, walking in the midst of the
fire, and they have no hurt; and the form of the fourth is like the Son of God."

Then Nebuchadnezzar came near to the mouth of the furnace, and he said: "Shadrach,
Meshach, and Abednego, servants of the Most High God, come forth and come hither!"

Then Shadrach, Meshach, and Abednego came forth of the midst of the fire.

And the Princes, Governors, and Captains, and the King's Counsellors, who were gathered
together watching, saw these men upon whom the fire had no power; nor was a hair of
their heads singed, neither were their coats changed, nor the smell of fire had passed on
them.

Then Nebuchadnezzar spake and said: "Blessed be the God of Shadrach, Meshach, and
Abednego, Who hath sent His angel and delivered His servants who trusted in Him, and
have changed the king's word, and yielded their bodies, that they might not serve nor
worship any god except their own God."

So Nebuchadnezzar made another decree, that if any one said anything against the God of
these three young men, he should be cut in pieces and his house destroyed—"because
there is no other god that can deliver after this sort."

And the king promoted Shadrach, Meshach, and Abednego in the province of Babylon.

This is a glorious chapter of one of the greatest deliverances of the Bible; and there are
plenty more!

XXIX. QUEEN ESTHER'S REQUEST

ESTHER 8.3-6
ESTHER was a very beautiful girl, and Ahasuerus the great King of the Medes and Persians
chose her to be his Queen, and he loved her very much.

Esther was not only beautiful in face, but she had a very beautiful character.

She belonged to the people of God, called the Jews, who had been carried away captives
from Palestine, and were now living in Persia.

Among these Jews was a man called Mordecai, who was much respected for his goodness,
and he sat in the King's Gate.

When Esther's father and mother died, Mordecai took the little girl and brought her up as
his own daughter. He taught her about God, and Esther was very obedient, and loved
Mordecai very dearly.

Mordecai took the little girl and brought her up.

Then Esther was made Queen, and things went on peacefully; until one day Mordecai
heard that there was a plot forming to kill King Ahasuerus. He at once secretly told Esther,
and she told the King; and the two conspirators were both hanged. But the King forgot to
thank Mordecai, though it was written down in the Chronicles of the Kingdom.

About that time the King took a great fancy to a man called Haman, who hated the Jews,
and especially Mordecai, because he did not bow down to him when he passed.

So Haman obtained leave from the King to fix a day when all the Jews should be killed in
the whole Kingdom.

But the City Shushan was much perplexed; for they knew, though the King did not, that
his beloved Queen was a Jewess!
When Mordecai found out all that was happening, he was bitterly grieved, and sent an
urgent message to Esther, and implored her to go in and tell the King, and beg him to
spare her people.

But Queen Esther sent back a message to Mordecai, to remind him that if anyone ventured
to go in to the King's inner Court, that person would certainly be put to death unless the
King should hold out his Golden Sceptre.

So Mordecai sent another urgent message to tell Esther that perhaps she had come to be
Queen, to do this very thing. But if she did nothing, then she and all the Jews would
perish!

Then Queen Esther begged Mordecai to gather all the Jews together who were in Shushan,
and to bid them fast and pray for three days; and she and her maidens would fast too; and
at the end of that time, she said, "I will go in to the King, which is not according to the
law, and if I perish, I perish."

Esther was brave because she knew that she had God on her side; and she believed that
He would answer the prayers they were all offering up.

QUEEN ESTHER BEFORE AHASUERUS.

So on the third day Queen Esther put on her Royal robes, and went into the Inner Court
and stood before the King.

When King Ahasuerus saw his beautiful young Queen standing there so meekly, he held
out the Golden Sceptre which was in his hand. And she drew near and touched the top of
the sceptre.

And when he asked her what request she had to make, the King must have been
astonished at her reply, for she only asked that the King and Haman should come to a
banquet which she had prepared for them. So when they came to the Banquet, the King
asked the Queen again what her petition was? And she said if the King and Haman would
come to a Banquet with her, again to-morrow, she would then tell the King what her
request was.

So Haman went out from Queen Esther's Banquet very proud; and he told his wife and his
friends of his second invitation, but he said that nothing was any pleasure to him, so long
as Mordecai, the Jew, sat in the King's Gate.

Then his wife and his friends advised him to make a gallows fifty feet high, and to get the
King to let him hang Mordecai on it.

But that night the King could not sleep, and one of his servants fetched a roll of the
Chronicles of the Kingdom, and he read to him how Mordecai had once saved the King's
life.

And in the morning the King asked Haman what would be suitable to do to "the man that
the King delighted to honour?"

But Haman little thought that when he proposed to set the man on the King's own horse,
dressed in the King's Royal clothes, that it would be Mordecai who was to be honoured,
and not himself!

But the King told Haman to lead Mordecai round the town, and to proclaim: "Thus shall it
be done to the man whom the King delighteth to honour."

After this Haman went to the Banquet that Esther had prepared. He little knew what the
Queen's request was going to be! For Esther told the King that a great plot had been made
to destroy her and all her people, and that this wicked Haman was the one who had
planned it all!

Then Haman was afraid before the King and Queen.

You can picture the anger of the King, and when he was told of the gallows which Haman
had prepared for Mordecai, he ordered that Haman should be hanged there at once.

Then the Queen begged that letters might be sent to stop all the Jews being killed, and
Ahasuerus sent urgent posts on mules and horses and swift dromedaries to tell the Jews
that they might stand up for their lives, and destroy any enemies who rose up against
them.

Thus God answered the prayers of that young Queen and her maidens, and of the Jews
who joined with her in fasting and praying, and sent them a great deliverance, the
remembrance of which has been handed down from generation to generation ever since.
 XXX. A GREAT RAIN, AND A TIRED
PROPHET

So Ahab ate and drank—but Elijah went up to the top of

Carmel, and cast himself upon the earth with his face
between his knees, and he said to his servant: "Go up now
and look towards the sea."

And the servant returned, saying he could not see anything.

Then Elijah said: "Go—" seven times. And when he came

back the seventh time, he said he could see a little cloud in
the sky, no bigger than a man's hand.

So Elijah hurriedly sent a message to the king, to prepare

his chariot, and get to his home quickly, or the rain which
was coming would stop him!

And as he spoke, the heavens became black with clouds,

and there was a great rain. And Ahab rode and went to
Jezreel.

And the hand of the Lord was on Elijah, and he ran before
Ahab's chariot, right to the entrance of Jezreel.

But when Ahab told his wife, the wicked queen, Jezebel,
that all her prophets were dead, Jezebel sent a message to
Elijah that she would kill him, as he had done the prophets
of Baal, by that time the next day!
And now, Elijah, who had been so wonderfully strong and
full of faith for this great scene, fled for his life when he
heard the threat of Queen Jezebel!

Hungry, thirsty, tired-out, he fled till he had passed

Beersheba, and had gone a whole day's journey into the
desert, before he felt he might be safe from Jezebel! Here
he cast himself under a juniper tree, and asked the Lord to
let him die!

Poor Elijah! For one brief moment his faith failed him! If
God had answered his prayer, Elijah would have missed the
great honour of going up to Heaven in a Chariot of Fire
without death at all!

And let us pause here, just to think for a moment about our
own prayers.

It seems to me that we are encouraged to tell God

everything; and then we are wise to leave the choice with
Him: asking Him to do that which, in His wisdom and love,
He knows to be best for us.

So the poor wearied Prophet prayed that he might die; and

then overpowered with fatigue, he fell asleep. And
meanwhile God was preparing for him, while he slept—as
He does so often for His faithful, and sometimes faithless,
children—and behold! An angel touched him, and said to
him: "Arise and eat!"
And when he looked up, there was a little cake of bread,
freshly baked, and a cruse of water standing ready by his
pillow!

And he ate and drank; and then, still so weary that he could
hardly hold up his head, he slept again!

Then the angel of the Lord came the second time and
touched him, and said: "Arise and eat; because the journey
is too great for thee!"

Oh, the compassion of God, Who knows just how we feel!

So Elijah obeyed; and he went in the strength of that food,
for forty days and forty nights, till he reached Horeb, the
Mount of God, where he found a cave and lodged there.

By and by he heard a Voice from the Lord speaking to him,

and it said: "What doest thou here, Elijah?"

Then Elijah said: "I have been very jealous for the Lord, but
now the Children of Israel have forsaken my God, and I,
even I, am the only one left, and they are going to kill me!"

And the Lord said: "Go out and stand on the mount before
the Lord."

Then the Lord passed by, and a great wind tore the rocks
and the mountains, and there was a great earthquake; but
the Lord was not in the earthquake nor in the fire that came
afterwards; and then there was a still, low voice. And when
Elijah heard that voice, he wrapped his face in his mantle
and went out and stood by the mouth of the cave.

Then the voice spoke to him again: "What doest thou here,
Elijah?" And again Elijah said that he was the only Prophet
left!