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ASSET PRICING

Asset Pricing is a field of finance which focuses on understanding the price dynamics of stocks, bonds, currencies, commodities, financial derivatives (options, mortgages, swaps, insurance), home loans and other assets. Asset pricing is composed of three different lines of thought: financial engineering, financial economics and fundamental analysis. Financial engineering rests on two techniques:

1] perfect or imperfect replication of the asset with simpler assets whose prices are known,

2] pricing a financial derivative by modeling its underlying asset(s) as a complex stochastic process whose parameters are calibrated to the market.

Financial engineering involves relatively little statistics. More often than not, we are not fitting the model to historical data. We are not concerned with identifying the most statistically efficient technique making use of every observation in a long historical time window. We are fitting the model to one observation only, which is the most recent snapshot of the market (cross-section of the market prices), but that fit must be perfect or nearly perfect.

On the contrary, financial economics

1] does not try to decompose a financial derivative into the underlying factors,

2] does not calibrate the pricing model to only one snapshot of the market, available at a specific moment of time.

The financial economics approach looks at each asset as a whole. It focuses on the historical distribution of the asset returns, as well as the projection of the future distribution of the returns. It compares the studied asset to all other assets in the market in terms of the expected return and expected risk. It then determines a "fair" price by penalizing the asset for each extra unit of risk. A landmark illustration of the financial economics approach is the Capital Asset Pricing Model (CAPM).

Fundamental analysis uses accounting principles to understand and project the cashflows of the entity which has issued an asset. The entity can be a company issuing stock or a bond, a country issuing a bond or a credit default swap, or an individual issuing a bond or seeking a loan (e.g. David Bowie's bond). Fundamental analysis is labor intensive and requires scrutiny of entity's managerial process, competitiveness and operational risks. Also fundamental analysis relies on contrasting the entity against other comparable players in the same cohort and projecting the profitability of the cohort itself. Usually, the cohort is defined as the intersection of all or some of the following sets: the same industry or innovative profile, the same geographic region or strategy of global positioning, the same size, the same type of customers, etc. Fundamental analysis has made many people rich. Still the results are not quite scalable because every new entity has to be scrutinized all again. Compare this to derivatives pricing (financial engineering).


ASSET PRICING SUBCATEGORIES


ASSET PRICING REFERENCES

Hull, J. (2011), Options, Futures, and Other Derivatives (8th ed), Pearson / Prentice Hall.

Duffie, D. (2001), Dynamic Asset Pricing Theory (3rd ed), Princeton University Press.

Bjork, T. (2009), Arbitrage Theory in Continuous Time (3rd ed), Oxford University Press.

Brigo, D., & Mercurio, F. (2006). Interest Rate Models - Theory and Practice (2nd ed). Springer-Verlag Berlin Heidelberg.

Lipton, A. (2001). Mathematical Methods for Foreign Exchange: A Financial Engineer's Approach. World Scientific.

Cochrane, J. H. (2003). Asset Pricing (revised ed). Princeton University Press.

Damodaran, A. (2006). Damodaran on Valuation: Security Analysis for Investment and Corporate Finance (2nd ed). Wiley, Hoboken, New Jersey.

McKinsey & Company Inc., Koller, T., Goedhart, M., & Wessels, D. (2015). Valuation: Measuring and Managing the Value of Companies (6th ed). Wiley, Hoboken, New Jersey.


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