Asset Pricing

Summary

A long time ago Oscar Wilde said “A cynic is a man who knows the price of everything, and the value of nothing.” Ever since, economists – perhaps the ultimate cynics since they study the dismal science – have tried to address this critique and reconcile the two. This is also what we will concern ourselves with in the Asset Pricing unit: we know the price of any financial asset since we can observe it in the financial markets but do not know its value. How do we make sure the price of assets is equal to its value? This is very important - wouldn’t you want to ensure that the price you pay for a house does not exceed its value? However, it is considerably more difficult than what it might first seem. We start with the fundamental theorem of asset pricing – a simple relation stating that the price of an asset equals the present value of future cash generated by the asset – decompose it in various ways and discover a surprisingly rich array of properties and insights that will allow us to get close to the answer of the question that has concerned economists for decades. This is paramount because it is the foundation for many other units in TB1 and TB2.

Importance to your Programme

This unit covers a range of ground-breaking ideas and concepts on which modern finance is built and are essential knowledge to be able to answer important questions in finance such as valuing assets, constructing portfolios, measuring fund performance that are covered in TB1 and TB2 units such as Quantitative Methods for Finance and Investment, Investment Management and Financial Modelling. Students will learn practical applications of the financial models and ideas in Excel, a spreadsheet package that is widely used in the industry and is very versatile and helpful. The students will also learn how to critically evaluate and analyse finance material such as academic research, company information or even articles in the financial press. As such, the unit will provide them with the skills they need to be able to understand the research literature, choose the most appropriate methods for a given type of problem, and conduct straightforward economic analysis when undertaking the investigative part of their dissertations.

Learning Outcomes

After completing this unit successfully, students should be able to:

•  Derive and explain standard asset pricing theories including the CAPM and APT.
•  Evaluate and compare the merits of these theories via an appreciation of empirical work in this area.
• Discuss the pricing of bonds and theories of the term structure of interest rates.
• Describe the basic features of various financial derivatives and derivatives markets.
• Employ simple absence of arbitrage techniques to price financial derivatives.

Content

The Asset Pricing course provides a thorough grounding in the pricing of financial securities. The lectures start with a discussion of interest rates before moving on to bond pricing. Equity markets and determination of equity prices are treated next before the theory behind and testing procedures for informational efficiency in financial markets are discussed. Finally, derivative securities and derivatives pricing are treated in detail.