To see why the assumption of frictionless market is crucial, consider the basic principle of standard asset pricing. The capital asset pricing model capm provides an initial framework for answering this question. Using finite dimensional techniques, this book avoids sophisticated mathematics and exploits. For debt, asset pricing is relatively simple, as cash flows to the owner are contractually fixed. The development of nancial asset pricing theory over the 35 yr since samuelsons 1965 article has been intertwined with the development of the theory of stochastic integration.
Fins4776fins5576 asset pricing theory course outline. For all the sessions students will need the class notes, the data files and a laptop with matlab. Both of them are based on the efficient market hypothesis, and are part of the modern portfolio theory. It will inform even experienced researchers about the fundamental assumptions necessary for deriving pricing implications from quite general, recursive, preferences. Financial asset pricing theory offers a comprehensive overview of the classic and the current research in theoretical asset pricing. Undoubtedly, the capital asset pricing model capm developed by sharpe 1964, lintner 1965, and mossin 1966 is the best known asset pricing model. The asset pricing results are based on the three increasingly restrictive assumptions. Under general equilibrium theory prices are determined through market pricing by supply and demand. Merton, robert 1973, an intertemporal capital asset pricing model, econometrica 41, 867887. The emphasis is on the interplay between theory and empirical work and on the tradeoff between risk and return. An integrated pricing model for defaultable loans and bonds jel classification.
I will start with a discussion of asset pricing and then turn to corporate finance. Empirical asset pricing the graduate school of finance. The investment capm lu zhang ohio state and nber busfin 8210 ohio state, autumn 2018. Topics covered include i noarbitrage, arrowdebreu prices, and equivalent martingale measures, ii security structure and market completeness, iii meanvariance analysis. Other more advanced references that may be used in class or consulted on specific topics. Arbitrage pricing theory, often referred to as apt, was developed in the 1970s by stephen ross. Capital asset pricing model and arbitrage pricing theory.
This is a thoroughly updated edition of dynamic asset pricing theory, the standard text for doctoral students and researchers on the theory of asset pricing and portfolio selection in multiperiod settings under uncertainty. This book is the frontier text for learning asset pricing theory from first principles. His theory predicts a relationships between the returns of a single asset as a linear function of many independent macroeconomic factors. Asset pricing in the standard assetpricing paradigm, it is assumed that investors directly invest their wealth in markets. Pdf a partial introduction to financial asset pricing. Using finite dimensional techniques, this book avoids sophisticated mathematics and exploits economic theory to clarify the essential structure of recent research in asset pricing. Asset pricing theory is an advanced textbook for doctoral students and researchers that offers a modern introduction to the theoretical and methodological foundations of competitive asset pricing. To study asset pricing theory, we will have to study how individual investors make decisions about consumption and investment. I argue that while the apt is compatible with the data available for testing theories of asset pricing, the capm is not. The capital asset pricing model and the arbitrage pricing.
Although this was an appropriate assumption for the united states in. Pareto optimality implies a representative investor 163 7. The modelderived rate of return will then be used to price the asset. Monetary economics this article compares two leading models of asset pricing. Asset pricing is developed around the concept of a stateprice deflator which relates the price of any asset to its future risky dividends and thus incorporates how to adjust for both time and risk in asset valuation. The capital asset pricing model capm and the arbitrage pricing theory apt have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. Theme a new class of capital asset pricing models arises from the rst principle of real investment for individual rms. Introduction to asset pricing theory the theory of asset pricing is concerned with explaining and determining prices of. To improve the discrepancy of the capm, the apt model was proposed by stephen ross 1976 as a general theory of asset pricing. Arbitrage pricing theory assumptions explained hrf. These models are born out of modern portfolio theory, with the capital asset pricing. The key message of the model is that the expected excess return on a risky.
A theory of market equilibrium under conditions of risk, journal of finance 19, 425442. The model can justify the equity premium, the risk. The password for opening the files will be sent to the students. The aim of this course is to introduce students to the modern theory of asset pricing, portfolio theory and derivatives pricing. The capital asset pricing model the capital asset pricing model capm is a theory in which the expected return on an asset is the sum of the return on a riskfree asset and the return commensurate with the assets market risk. Continuoustime asset pricing theory expresses a rich body of central results in financial economics from the perspective of models in which agents can revise their decisions continuously in time. Pdf asset pricing theory princeton series in finance.
October 5, 2015 darrell du e notes that the 1970s were a \golden age for asset pricing theory, but suggests that the period since has been \a moppingup operation du e, dynamic asset pricing theory, preface. Finance theory and asset pricing, second edition oxford university press 2003. Asset pricing the authors model consumption and dividend growth rates as containing both a small longrun predictable component and fluctuating economic uncertainty consumption volatility. Here asset prices jointly satisfy the requirement that the quantities of each asset supplied and the quantities demanded must be equal at that price so called market clearing. In finance, arbitrage pricing theory apt is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factorspecific beta coefficient. Asset pricing theory phd course the einaudi institute for. Markowitz is best known for his initiation of the modern portfolio choice. Lecture notes in macroeconomics asset pricing asset pricing sits on the border of two areas of macro. Topics include microeconomic foundation of asset pricing theory, the noarbitrage principle and fundamental theorem, risk measurement and risk management, sequential portfolio choice, equity. That takes some of the glamor out of the subject, but hes right, the basic theory has been. Description theory of asset pricing unifies the central tenets and techniques of asset valuation into a single, comprehensive resource that is ideal for the first phd course in asset pricing. The asset prices we discuss would include prices of bonds and stocks, interest rates, exchange rates, and derivatives of all these underlying.
Litzenberger, foundations for financial economics, north holland. Asset pricing theory tries to understand the prices or values of claims to uncertain payments. In this chapter, we shall introduce the basic theory of asset pricing and portfolio management in the discrete time case. Asset pricing wikibooks, open books for an open world. Arbitrage pricing theory apt an alternative model to the capital asset pricing model developed by stephen ross and based purely on arbitrage arguments. The last part of the chapter is devoted to the fundamental theorem of asset pricing, which relates the absence of arbitrage opportunities to the existence of a strictly positive linear pricing. The fame of the laureates extends far beyond nancial economics. By striking a balance between fundamental theories and cuttingedge research, pennacchi offers the reader a wellrounded introduction to modern asset pricing theory that does not require a high level of. Asset pricing is developed around the concept of a stateprice deflator which relates the price of any asset to its future risky dividends and thus incorporates how to adjust for both time and risk in asset.
A low price implies a high rate of return, so one can also think of the theory as explaining why some assets pay higher average returns than others. Finance theory and asset pricing provides a concise guide to financial asset pricing theory for economists. Assuming that the wellbeing of an individual can be represented by some sort of utility function, we will have to maximize utility subject to various constraints, e. Arbitrage pricing theory apt is a multifactor asset pricing model based on the idea that an assets returns can be predicted using the linear relationship between the assets expected return. When implemented correctly, it is the practice of being able to take a positive and. A simple version of the ccapm cannot explain various stylized asset pricing facts, but these asset pricing puzzles can be resolved by a number of recent extensions involving habit formation, recursive utility, multiple consumption goods, and longrun consumption risks. Asset pricing and portfolio choice theory second edition. These dynamics, for which they provide empirical support, in conjunction with generalized recursive preferences, can explain key asset markets phenomena. Modern research seeks to understand the behavior of the stochastic discount factor sdf. Theory and evidence 29 thus, j3im is the covariance risk of asset i in m measured relative to the average covariance risk of assets, which is just the variance of the market return. A key breakthrough occurred in the early 1970s when black and scholes 1973 and merton 1973. Finance theory and asset pricing frank milne oxford.
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