Asset Pricing

Financial markets serve several purposes:

1. Allowing investors to shift consumption in time
2. Allowing the transfer of risk between different investors
3. Moving capital from those who have it to those who can use
it productively
Asset pricing is the study of how financial assets are priced.
Financial assets include several varieties:
1. Debt
2. Equities
3. Hybrids
4. Derivatives
Whatever the particular variety, we can think of financial assets
simply as the right to a future cash flow stream and/or physical
asset. All types of asset, e.g., debt, equity, etc., can be reduced to
a stream of cash flows that can be valued.
When valuing a stream of cash flows we need to consider these
things:
Time value of money
Riskiness of the cash flows
Expected value of the cash flows
For debt, asset pricing is relatively simple, as cash flows to the
owner are contractually fixed. For example, the holder of a 20year US government bond with a face value of $100 and a coupon

of 5% paid annual can expect (with high certainty) to be paid $5 a

year for the next 20 years, with $100 to be returned at the end of
20 years. The value of the bond is the present value of the future
cash flows. If the required rate of return is r=3% a year, then the
value is: $5*(1-(1+r)^-20)/r + 100*(1+r)^-20 = $129.75.
Although debt security can have predictable cash flow in the
future (e.g., assuming we are talking about fixed rate debt
security) there still is an element of uncertainty because expected
rate of return is likely to change over the above mentioned 20
years time period. This would change the present value of the
debt security depending on the assumption or derivation of the
rate of return that applies to each individual time period. This
adds interest rate risk component to the debt security
valuation.
If the debt issuer is not a "AAA" rated sovereign state then we
cannot assume the cash flow is guaranteed. This adds a credit
risk component. Debt securities issued by all entities are rated by
investment grade rating services (e.g.,. Moody's, Standard &
Poor's) and this can be used to determine the required rate of
return to account for the risk, which will the impact the valuation
of the debt security.
For equities, asset pricing is more difficult as future cash flows are
uncertain, and vary with both economic conditions and the
fortune of the company. We need to project future expected cash
flows, and also determine the expected return of the stock. The
estimated expected return of the stock is based on an estimate of
how risky the cash flows are. We can decompose risk into a)
common factor risk and b) idiosyncratic risk. The latter can be
diversified away in a portfolio, so earns no return premium. The
former cannot be diversified away, so earns a risk premium.