Language
Country/Area
No result found
CAPM and CCAPM: What's the Secret Behind These Asset Pricing Models?
In financial economics, asset pricing refers to the formal treatment and development of two interrelated pricing principles. What needs to be explored here is the operation of the basic asset pricing model and its application. Although there are many models designed for different situations, these models can basically be categorized as general equilibrium asset pricing or rational asset pricing. These models have a significant impact on the decision-making process of investors when choosing investments.
General equilibrium theory holds that prices are determined by market supply and demand, and the market will only reach liquidation when supply and demand are balanced.
In the framework of general equilibrium asset pricing, prices satisfy the requirement that the quantity supplied of each asset is equal to the quantity demanded, which is known as market clearing. Therefore, these models have their roots in Modern Portfolio Theory, represented by the Capital Asset Pricing Model (CAPM). These models operate based on macroeconomic variables. For example, for CAPM, the impact of the "overall market" is considered; for CCAPM, the impact of overall wealth is considered to further reflect individual preferences.
The main goal of these models is to establish a statistical probability distribution of the prices of "all" securities over a specific future investment horizon, so these models have "large dimensionality".
General equilibrium pricing creates one asset price for multiple assets when evaluating a diversified portfolio.
According to this theory, calculating the value of an investment or stock requires three steps: first, making a financial forecast for the business or project; second, discounting the resulting cash flows at the interest rate returned by the chosen model, which is the current rate. The risk of these cash flows is reflected; finally, these present values are added together to obtain the final value. Another option here, although not as common as the above model, is called "fundamental valuation", which uses a company's expected financial performance to simulate earnings.
Reasonable pricing
Under a rational pricing framework, derivative prices are calculated so that they correspond to more fundamental (equilibrium-determined) security prices and do not generate risk-free arbitrage opportunities. The characteristic of this approach is that assets are usually not grouped, but a unique risk price is established for each asset, so these models are "low-dimensional".
Classic models such as Black-Scholes describe the dynamics of markets including derivatives.
The calculation of option prices and their "Greeks" (i.e., sensitivities) combines two parts: a model of the asset's price behavior, which is calibrated based on market observations; and a return on the option's price. Cost is used as a mathematical method to dye eight benchmark value ranges. Such models are also used to price fixed-income instruments such as bonds, which consist of only one asset.
Interrelationship of principles
These pricing principles are closely interrelated and are usually described by the fundamental theorem of asset pricing. In short, this means that in the absence of arbitrage, the market imposes a probability distribution over a range of potential market scenarios, called a risk-neutral or equilibrium measure, and determines the market price by using the discounted expectation .
All pricing models can be derived as a function of a "state price", which is related to the benefit when a specific state occurs at a specific time.
For example, the CAPM can be derived by relating risk aversion to overall market returns, while the Black-Scholes model is obtained by assigning a binomial probability to each possible spot price. These models play a pivotal role in financial economics, especially in uncertainty management and risk aversion.
In the process of understanding these asset pricing models, how many investors begin to consider how their decision-making process relates to the structure of the market?
