Asset pricing

Asset Pricing is a field of study that seeks to determine the value of financial assets. This discipline is fundamental to financial economics, as it provides the theoretical underpinnings for many financial decisions, such as investment and risk management.

Overview

The basic principle of asset pricing is that the price of a financial asset reflects the present value of its expected future cash flows. This is often referred to as the present value principle. The expected future cash flows are discounted at a rate that reflects the riskiness of the cash flows. The higher the risk, the higher the discount rate, and thus the lower the present value of the cash flows.

Models of Asset Pricing

There are several models used in asset pricing, each with its own assumptions and implications. These include the capital asset pricing model (CAPM), the arbitrage pricing theory (APT), and the Black-Scholes model.

Capital Asset Pricing Model

The CAPM is a model that describes the relationship between the expected return of a security and its systematic risk. The model assumes that investors are risk-averse and hold diversified portfolios. The expected return of a security is determined by its beta, which measures its sensitivity to market movements.

Arbitrage Pricing Theory

The APT is a model that extends the CAPM by allowing for multiple sources of systematic risk. The model assumes that in the absence of arbitrage opportunities, the expected return of a security is a linear function of its exposures to various risk factors.

Black-Scholes Model

The Black-Scholes model is a model used to price derivative securities, such as options. The model assumes that the price of the underlying asset follows a geometric Brownian motion with constant volatility.

Empirical Evidence

Empirical tests of asset pricing models have provided mixed results. While these models can explain a large portion of the variation in asset returns, they often fail to fully account for the observed patterns in the data, such as the value premium and the momentum effect.

See Also

• Financial economics
• Investment theory
• Risk management