Asset pricing

Asset pricing models
Regime

Asset class
 Equilibrium
pricing		 Risk neutral
pricing

Equities

(and foreign exchange and commodities (and interest rates) for risk neutral pricing)

Bonds, other interest rate instruments
For the corporate finance usage, see Valuation (finance).

In financial economics, asset pricing refers to a formal treatment and development of two main pricing principles,[1] outlined below. "Investment theory", which is near synonymous, encompasses the body of knowledge used to support the decision-making process of choosing investments.[2]

The first principle: general equilibrium asset pricing where prices are determined through market pricing by supply and demand. The second: rational pricing where (usually) derivative prices are calculated such that they are arbitrage-free with respect to more fundamental (equilibrium determined) securities prices. Under the first, the models are born out of modern portfolio theory, with the Capital Asset Pricing Model as the prototypical result; the second leads to the Black–Scholes model with its option pricing formula, and more generally, Martingale pricing. These principles are interrelated through the Fundamental theorem of asset pricing.

General Equilibrium Asset Pricing

An equilibrium asset pricing model is one in which the asset prices jointly satisfy the requirement that the quantities of each asset supplied and the quantities demanded must be equal at that price.

Rational Pricing

Rational pricing is the assumption in financial economics that prices of assets (including within asset pricing models) will represent the arbitrage-free pricing level for those assets.

Both sets are extended to models for more complex phenomena and situations, and asset pricing then overlaps with mathematical finance. Here, corresponding to the above distinction, an important difference is that these use different probabilities: respectively, the real-world (or actuarial) probability, denoted by "P", and the risk-neutral (or arbitrage-pricing) probability, denoted by "Q".

For an overview of the development of the CAPM and Black-Scholes, see Financial economics #Uncertainty; for the more advanced approaches, see #Extensions.

See also

References

  1. ↑ John H. Cochrane (2005). Asset Pricing. Princeton University Press. ISBN 0691121370.
  2. ↑ William N. Goetzmann (2000). An Introduction to Investment Theory (hypertext). Yale School of Management
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