Theory of asset pricing

Abstract

The central goal of asset pricing is to determine the prices or values of claims to uncertain payments. This is challenging because the timing and the risk of uncertain payments have to be taken into account simultaneously. A low price implies a high rate of return, so one can also think of asset pricing as explaining why some assets exhibit higher returns than others. Intuitively, if we lived in a world without risk, the price of an asset would simply be the sum of its future cash flows, discounted using the risk-free rate. Over the last three decades theoretical and empirical developments in modern asset pricing have taken place within a well established paradigm. This paradigm emphasizes the structure placed on financial asset returns by the assumption that asset markets do not permit the presence of arbitrage opportunities — loosely, opportunities to make riskless profits on an arbitrarily large scale. In the absence of arbitrage opportunities, there exists a stochastic discount factor that relates payoffs to market prices for all assets in the economy. This can be understood as an application of the Arrow-Debreu model of general equilibrium to financial markets. A state price exists for each state of nature at each date, and the market price of any financial asset is just the sum of its possible future payoffs, weighted by the appropriate state prices. Further assumptions on the structure of the economy produce stronger results. For example, if markets are complete, the stochastic discount factor is unique. If the stochastic discount factor is linearly related to a set of common shocks, then a linear factor model describes asset returns. If the economy is populated by a representative agent with a well defined utility function, the stochastic discount factor is related to the marginal utility of aggregate consumption. Even recent developments in behavioral finance, which emphasize nonstandard preferences or irrational expectations, can be understood within this paradigm. Unfortunately, because these conditions of modern asset pricing are so general, they place almost no restrictions on real world financial data. Therefore, the challenge for future research is to understand the economic forces that determine the stochastic discount factor, or put another way, the rewards that investors demand for bearing particular risks. Specifically, financial economists need to understand and measure the sources of macroeconomic risks that drive asset prices. Recent papers argue that expected returns vary across assets in ways that are linked to macroeconomic variables, such as ‘recession’ or ‘financial distress’ factors.1 KeywordsAsset PriceDiscount FactorRisk PremiumExcess ReturnRelative Risk AversionThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.