Modern Financial Systems: Theory and Applications

CHAPTER 8

Pricing Stocks and Bonds

This chapter focuses on methods for valuing financial instruments under risk, in markets where all opportunities for arbitrage have been taken up. This review provides a point of departure for studying securities price relations in practice. Some highly active markets exhibit price relations that conform closely to the results of financial theory, while other markets exhibit large and persistent deviations from theoretical predictions. Hence after summarizing the principal results of asset pricing theory, the chapter attempts to assess the pricing implications of various market imperfections. While financial research is actively concerned with assessing the pricing effects of influences like informational differences, a practical explanation of asset price relations in different markets is still far from being fully realized. Nevertheless, it is possible to present some qualitative guidelines for valuing instruments in practice.

Perhaps the most straightforward way of pricing a security is to compare its price to those of other similar securities when trading profit opportunities have been eliminated. Thus, Chapter 8 reviews the pricing of corporate securities in the assumed absence of arbitrage opportunities. Conveniently, arbitrage-free prices are related to each other by an underlying measure known as a risk-neutral probability. The chapter shows both how risk-neutral probabilities can be found, and how the values of securities with different ...