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The secret of asset pricing: How does the market determine prices through supply and demand?
In financial economics, asset pricing is the formal construction and development of two interrelated pricing principles. These principles provide a framework for market participants to understand how prices are determined based on supply and demand. The market is not just a trading platform, but a complex system affected by multiple factors. Let’s delve deeper into this topic.
General equilibrium asset pricing
According to general equilibrium theory, prices are determined through market supply and demand. Asset prices must meet the requirement that the supply and demand of each asset are equal at that price, which is the so-called market clearing. In this model, prices are based on macroeconomic variables and individual preferences are no longer the dominant factor in determining prices.
These models are designed to model statistically derived probability distributions of market prices over a specific future investment horizon.
For the Capital Asset Pricing Model (CAPM), the overall market and the risk tolerance of individual investors are its core areas. Therefore, calculating the value of an investment or stock requires considering a financial forecast, then discounting the forecast cash flows, and finally aggregating these present values to return its actual value. This valuation method is unique and reflects the risks faced by the investment.
Rational pricing
Under the framework of rational pricing, the price of derivatives is calculated based on the basic equilibrium (ie, equilibrium determined) security price. Such pricing does not allow the existence of arbitrage. This approach typically does not group assets into groups, but rather creates a unique risk price for each asset. Rational pricing models are relatively low-dimensional, meaning they focus primarily on the performance of specific assets rather than the dynamics of the market as a whole.
Calculating option prices and their "Greeks" combines a specific asset pricing model and its calibrated parameters.
Classical pricing models such as the Black-Scholes model describe market dynamics including derivatives. The role of these models is to help investors grasp market risks and their potential returns, allowing investors to understand the complexity of the market while seeking the best returns.
Interrelationships between principles
These asset pricing principles are related to each other through the fundamental theorem of asset pricing. In the absence of arbitrage, the market imposes a probability distribution over possible market scenarios, called a risk-neutral or equilibrium measure. This theory provides a perspective that enables financial decisions to be made using risk-neutral probability distributions consistent with observed equilibrium prices.
The Capital Asset Pricing Model (CAPM) can be derived by relating risk aversion to overall market returns.
Further discussion can reveal that these models can also be derived based on "state prices". The so-called state prices refer to contracts that pay one unit of currency or goods when a specific event occurs at a specific time. Such models prompt market participants to explore the nature of price formation.
From general equilibrium to rational pricing, these two theories provide different perspectives for understanding the market, revealing to us the complex supply and demand relationship behind asset prices. The choices investors face, and the consequences they may bring, are thought-provoking. Under the guidance of these models, can we capture market dynamics more effectively and make more informed investment decisions?
