CHAPTER 7Some Foundations

For many years, academics have wrestled with fundamental questions of how prices of assets are determined. The theory of asset pricing provides a foundation for the evaluation of financial assets—asset pricing models. In this chapter, we cover some basic elements of the theory in order to provide background for evaluating the techniques and methods described later on and to place the return expectations in context. Many of the performance evaluation techniques that we review flow from asset pricing models, so understanding them should prove beneficial.

THE RISK-FREE RATE

We begin with a discussion of the risk-free rate, usually symbolized as Rf. This rate represents the minimum an investor could expect for investing ...

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