Asset Pricing Chapter II. The Challenge of Asset Pricing: A Roadmap - - PowerPoint PPT Presentation

Introduction 2.1 The « key » question: how to value a cash flow? 2.2 Discounting a risky cash flow 2.3 fundamental approaches Roadmap

Asset Pricing

Chapter II. The Challenge of Asset Pricing: A Roadmap June 20, 2006

Asset Pricing

Introduction 2.1 The « key » question: how to value a cash flow? 2.2 Discounting a risky cash flow 2.3 fundamental approaches Roadmap

A Roadmap

« The ideas of economists and political philosophers .. are more powerful than commonly understood. Indeed the world is ruled by little else. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. » J.M. Keynes

Asset Pricing

Introduction 2.1 The « key » question: how to value a cash flow? 2.2 Discounting a risky cash flow 2.3 fundamental approaches Roadmap

Table 2.1 : Valuing a Risk-Free Cash Flow t = 0 t = 1 t = 2 t = T −3mio 1mio 2mio 3mio

1mio (1+r f

1)

1mio (1+r f

2)2

1mio (1+r f

3)3

$1 dollar today = $1 dollar tomorrow

Asset Pricing

Introduction 2.1 The « key » question: how to value a cash flow? 2.2 Discounting a risky cash flow 2.3 fundamental approaches Roadmap 1

E ˜ CF 1 (1 + r f

1 + π);

E ˜ CF 2 (1 + r f

2 + π)2 ;

E ˜ CF 3 (1 + r f

3 + π)3 ; or E ˜

CF τ − Πτ (1 + r f

τ)τ

.

2

ˆ E ˜ CF τ (1 + r f

τ)τ ;

3

• θτ∈Θτ

q(θτ)CF(θτ),

Asset Pricing

Introduction 2.1 The « key » question: how to value a cash flow? 2.2 Discounting a risky cash flow 2.3 fundamental approaches Roadmap

2 fundamental approaches

Equilibrium approach: from first principles starting with hypotheses on the structure of the economy and the behavior of economic agents. By arbitrage: « piggybacking » on existing price

• bservations

Asset Pricing

Introduction 2.1 The « key » question: how to value a cash flow? 2.2 Discounting a risky cash flow 2.3 fundamental approaches Roadmap

Equilibrium price of a bicycle

Analysis of supply and demand for bicycles and substitute products Needed: A theory of demand for investments Starts with postulates on behavior and derivation of their consequences

Asset Pricing

Introduction 2.1 The « key » question: how to value a cash flow? 2.2 Discounting a risky cash flow 2.3 fundamental approaches Roadmap

Arbitage pricing of bicycles

Bicycle: 2 wheels: pw x 2 1 saddle: ps x 1 1 frame: pf x 1 1 gearshift: pg x 1 2 brakes: pb x 2 pbicycle (free labor)

Asset Pricing

Introduction 2.1 The « key » question: how to value a cash flow? 2.2 Discounting a risky cash flow 2.3 fundamental approaches Roadmap

THE ROADMAP

Equilibrium Arbitrage Preliminaries Utility theory

• Ch.3-4

Investment de- mand - Ch.5-6 Computing risk premia CAPM - Ch.7 CCAPM - Ch.9 APT - Ch. 13 Identifying distorted probabilities Martingale measure -

• Ch. 11 & 12

Pricing future dollars state by state A-D pricing I - Ch. 8 A-D pricing II -

• Ch. 10

New Chapter on Asset management: Ch.14 Incomplete markets and Modigliani-Miller: Ch.15 Heterogeneous Information and the Efficient Market

Asset Pricing