Asset Pricing

Asset pricing studies how securities are valued and how risk premia are determined. It explains why assets with similar cash flows can trade at different prices due to risk and investor preferences.

Core Ideas

Investors demand compensation for bearing risk. Prices reflect expected cash flows discounted by a rate that includes a risk premium. Differences in risk exposure lead to differences in expected return.

Key Models

Classic models include the Capital Asset Pricing Model and multi factor models. Arbitrage pricing frameworks link expected returns to multiple sources of systematic risk. Consumption based models connect asset returns to macroeconomic conditions.

Applications in Trading

Asset pricing concepts guide factor design, valuation metrics, and risk models. They help identify mispricings and build portfolios with targeted exposures. Understanding risk premia also informs hedging and leverage decisions.

Limitations

Models rely on assumptions such as efficient markets or stable relationships. Market frictions, behavioral biases, and structural breaks can cause deviations from model predictions.

Conclusion

Asset pricing provides the theoretical foundation for many trading strategies. It is most effective when combined with realistic assumptions and empirical validation.