Asset Pricing Theory

Synopsis

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. Costis Skiadas develops in depth the fundamentals of arbitrage pricing, mean-variance analysis, equilibrium pricing, and optimal consumption/portfolio choice in discrete settings, but with emphasis on geometric and martingale methods that facilitate an effortless transition to the more advanced continuous-time theory.

Among the book's many innovations are its use of recursive utility as the benchmark representation of dynamic preferences, and an associated theory of equilibrium pricing and optimal portfolio choice that goes beyond the existing literature.

Asset Pricing Theory is complete with extensive exercises at the end of every chapter and comprehensive mathematical appendixes, making this book a self-contained resource for graduate students and academic researchers, as well as mathematically sophisticated practitioners seeking a deeper understanding of concepts and methods on which practical models are built.

• Covers in depth the modern theoretical foundations of competitive asset pricing and consumption/portfolio choice

• Uses recursive utility as the benchmark preference representation in dynamic settings

• Sets the foundations for advanced modeling using geometric arguments and martingale methodology

• Features self-contained mathematical appendixes

• Includes extensive end-of-chapter exercises

Excerpt

Asset pricing theory tries to understand the prices or values of claims to uncertain payments. 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.

To value an asset, we have to account for the delay and for the risk of its payments. The effects of time are not too difficult to work out. However, corrections for risk are much more important determinants of many assets' values. For example, over the last 50 years U.S. stocks have given a real return of about 9% on average. Of this, only about 1% is due to interest rates; the remaining 8% is a premium earned for holding risk. Uncertainty, or corrections for risk make asset pricing interesting and challenging.

Asset pricing theory shares the positive versus normative tension present in the rest of economics. Does it describe the way the world does work, or the way the world should work? We observe the prices or returns of many assets. We can use the theory positively, to try to understand why prices or returns are what they are. If the world does not obey a model's predictions, we can decide that the model needs improvement. However, we can also decide that the world is wrong, that some assets are “mis-priced” and present trading opportunities for the shrewd investor. This latter use of asset pricing theory accounts for much of its popularity and practical application. Also, and perhaps most importantly, the prices of many assets or claims to uncertain cash flows are not observed, such as potential public or private investment projects, new financial securities, buyout prospects, and complex derivatives. We can apply the theory to establish what the prices of these claims should be as well; the answers are important guides to public and private decisions.

Asset pricing theory all stems from one simple concept, presented in the first page of the first chapter of this book: price equals expected discounted payoff. The rest is elaboration, special cases, and a closet full of tricks that make the central equation useful for one or another application.

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