Chapter 3. Asset Pricing Models

Covered in this chapter are the problem of absolute pricing (Cochrane 2005) and how the value of assets with uncertain payments is determined based on their risk. Chapter 2, Portfolio Optimization, modeled the decision-making of an individual investor based on the analysis of the assets' return in a mean variance framework. This chapter focuses on whether or not equilibrium can exist in financial markets, what conditions are needed, and how it can be characterized. Two main approaches—Capital Asset Pricing Model and Arbitrage Pricing Theory—will be presented, which use completely different assumptions and argumentation, but give similar descriptions of the return evolution.

According to the concept of relative pricing, the riskiness of the underlying product is already involved in its price and, so, it does not play any further role in the pricing of the derived instrument; this will be presented in Chapter 6, Derivatives Pricing. The no-arbitrage argument...