ACCOUNTING AND MANAGERIAL FINANCE

Accounting and Managerial Finance



Accounting and Managerial Finance

Asset Pricing Models

One of the central questions in financial economics is how to assign a correct value to an asset that provides a stream of uncertain future cash flows. At the most general level, the solution is simple: The price of the asset today equals the expected discounted value of its future payoffs. This discounting—the assignment of a (usually) lower present value to future cash flows—reflects the time and risk dimensions of the payoffs offered by the asset. First, most investors value a dollar received today more than they value a dollar received tomorrow. Consequently, they are willing to pay less than one dollar today for a dollar that they will receive in the future. This is the time dimension of asset pricing. Second, because investors dislike uncertainty and demand a compensation for bearing extra risk, the rate at which the payoffs are discounted should reflect how risky these payoffs are. Riskier payoffs are discounted more heavily than payoffs that are less risky.

This is the risk dimension of asset pricing. The variation in riskiness across assets gives rise to variation in their expected returns: Because of higher discounting, assets with a riskier payoff pattern should have a lower price and hence, provide higher expected returns than assets that are otherwise similar but have less risky payoffs. This higher expected return is the reward that investors demand so that they are willing to include the risky asset in their portfolios. In equilibrium, then, the rate of return on an asset should be aligned with its riskiness in order for demand by risk-averse investors to meet supply. Hence, the interplay between risk and return—the search for the fundamental sources of risk and the quantification of this risk—lies at the heart of asset pricing research.

Asset pricing theory provides guidance on how assets optimally should be priced and how investors optimally should invest under some assumptions specified in the theoretical models. On the other side of the coin, asset pricing research also aims to understand how assets actually are priced on real financial markets. Thus, there is a close interplay between theory and practice. For investors operating in the financial markets, it is of fundamental interest to know the fair price of any given financial asset and the return they can expect to get from their risky investments.

Furthermore, using the tools of modern portfolio theory, investors can quantify the trade-off between risk and return to construct optimal portfolios that suit their own risk preferences. Hence, asset pricing theory has vast practical implications and applications. Considering this, it is not surprising that the advent of modern portfolio theory and asset pricing models revolutionized Wall Street and the field of investment management. See, for example, Peter Bernstein (2005), who provides a historical account of the interplay between theory and practice of financial economics.

This chapter proceeds as follows: First, the general framework for understanding risk and return is ...