October 2024
Intermediate to advanced
432 pages
16h 57m
English
Content preview from Contemporary Finance
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5Capital Markets: How Asset Prices Are Determined
The market-clearing process determines asset prices and prospective returns by finding momentary equilibrium prices, given the supply and demand for securities. Equilibrium asset prices express current “consensus” risk preferences, possible payoffs in the future, and investors’ information and expectations about them. Why do market prices end up where they do in equilibrium? The steps in the explanation are:
- Take the menu of available assets, the prospective returns, and their risks as given and identify among the range of possible investment choices the portfolios that just waste opportunities.
- Specify investor preferences and explain how people choose among the remaining, efficient portfolios.
- Once we know how individuals make their choices, how does the market clear and establish asset prices at a point in time and thus, the prospective returns we take as given in the first step?
5.1 Portfolios, Diversification, and Investor Choice
5.1.1 Portfolio Risk
Diversification refers to combining assets in portfolios. Investors can not only mix the characteristics of the constituent assets but also expand the investment choices available to them. Diversification is powerful; it can lead to a reduction of risk without sacrificing return.
Investment choices can be summarized by identifying the available combinations of portfolio expected return and portfolio return variance or volatility, based on the expected returns, volatilities, ...
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