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Financial Economics by Guofu Zhou, Edwin H. Neave, Frank J. Fabozzi

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17

PRICING CORPORATE SECURITIES

Financiers and investors spend much of their time establishing the values of financial instruments. For example, a financier needs to assess the value of a loan contract in order to determine the extent to which funds can profitably be advanced against it, and a trader needs an estimate of what a security might be worth before bidding to acquire it. Since risks can vary greatly across financial instruments, it is important to determine how risk and value are related. It would be even more important to have systematic ways of recognizing how uncertainty affects the valuation (or pricing) of a financial instrument, but this part of financial theory is still relatively underdeveloped, partly because the effects of uncertainty are largely unquantifiable.

In the first four chapters of Part IV of this book, we have focused on methods for valuing financial instruments under risk in markets where all opportunities for arbitrage have been taken up. This provides a point of departure for studying securities price relations in real-world financial markets. Some highly active financial markets exhibit price relations that conform closely to the results of financial theory, while other markets exhibit large and persistent deviations from theoretical predictions. Financial research is actively concerned with assessing the pricing effects of influences like informational differences, but a practical explanation of asset price relations in different markets is still ...

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