Finance: Capital Markets, Financial Management, and Investment Management

CHAPTER 8

Asset Valuation: The Theory of Asset Pricing

The pricing of assets is a topic that cuts across financial and asset management. In financial management, a firm wants to know the cost of capital and the return required before investing in a long-term investment project. In portfolio management, a key input in portfolio construction is the expected return for an asset. Asset pricing models describe the relationship between the risks of and the expected return. As we will see in later chapters, an estimate of the expected return that providers of capital require on investments is needed in order to value an asset. So, while we refer to asset pricing models in this chapter, we mean the expected return investors require given the risk associated with an investment.

The two most well-known equilibrium pricing models are the capital asset pricing model developed in the 1960s and the arbitrage pricing theory model developed in the mid-1970s. In this chapter, we describe these two models and we present their applications in later chapters.

CHARACTERISTICS OF AN ASSET PRICING MODEL

In well-functioning capital markets, an investor should be rewarded for accepting the various risks associated with investing in an asset. Risks are also referred to as “risk factors” or “factors.” We can express an asset pricing model in general terms based on risk factors as follows:

(8.1)

where ...