Encyclopedia of Financial Models I

General Principles of Asset Pricing

GUOFU ZHOU, PhD

Frederick Bierman and James E. Spears Professor of Finance, Olin Business School, Washington University in St. Louis

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: Asset pricing is mainly about transforming asset payoffs into prices. The most important principles of valuation are no-arbitrage, law of one price, and linear positive state pricing. These principles imply asset prices are linearly related to their discounted payoffs in which the stochastic discount factor is a function of investors’ risk tolerance and economy-wide risks. The arbitrage pricing theory, the capital asset pricing model, and the consumption asset pricing model, among others, are special cases of the discount factor models.

In this entry, we discuss the general principles of asset pricing. Our focus here is to analyze asset pricing in a more general setup. Due to its generality, this entry is inevitably more abstract and challenging, but important for understanding the foundations of modern asset pricing theory. First, by extending the state-dependent contingent claims with two possible states allowing for an arbitrary number of states, we introduce the economic notions of complete market, the law of one price, and arbitrage. Then, we provide the fundamental theorem of asset pricing that ties these concepts to asset pricing relations. Subsequently, we discuss stochastic discount factor models, which is the unified ...