The asset pricing models of financial economics describe the prices and expected rates of return of securities based on arbitrage or equilibrium theories. These models are reviewed from an empirical perspective, emphasizing the relationships among the various models.
Asset pricing models describe the prices or expected rates of return of financial assets, which are
Claims traded in financial markets. Examples of financial assets are common stocks, bonds, options, and futures contracts. The asset pricing models of financial economics are based on two central concepts. The first is the ”no arbitrage principle,” which states that market forces tend to align the prices of financial assets so as to eliminate arbitrage opportunities. An arbitrage opportunity arises if assets can be combined in a portfolio with zero cost, no chance of a loss, and a positive probability of gain. Arbitrage opportunities tend to be eliminated in financial markets because prices adjust as investors attempt to trade to exploit the arbitrage opportunity. For example, if there is an arbitrage opportunity because the price of security A is too low, then traders’ efforts to purchase security A will tend to drive up its price, which will tend to eliminate the arbitrage opportunity. The arbitrage pricing model (APT), (Ross, 1976) is a well-known asset pricing model based on arbitrage principles.
The second central concept in asset pricing is ”financial market equilibrium.” Investors’ desired holdings of financial assets are derived from an optimization problem. A necessary condition for financial market equilibrium in a market with no frictions is that the first-order conditions of the investor’s optimization problem are satisfied. This requires that investors are indifferent at the margin to small changes in their asset holdings. Equilibrium asset pricing models follow from the first-order conditions for the investors’ portfolio choice problem, and a market-clearing condition. The market-clearing condition states that the aggregate of investors’ desired asset holdings must equal the aggregate”market portfolio” of securities in supply.