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Asset Pricing in Financial Markets

Updated: Jul 1, 2020

By Shubham Bansal

In general accounting terms, Assets are defined as resources owned by an individual or entity which are likely to generate future economic benefits as well as a spurt in the wealth. In financial markets, some of the assets such as shares, bonds and derivatives are traded and held upon in order to gain, owing to increase in the value of such assets over the period of time. There are numerous factors which lead to determination of price of the above-mentioned assets which shall be discussed in the later part.

It is known to all that financial markets use the very basic rule of “Demand-supply” to determine the price of an asset. However, there are several models such as CAPM which guide the investor in determining the optimum price of an asset. These models consider various assumptions and factors while calculating the value of stock or asset. Each model is backed by statistical proofs and formula which increase their credibility. All the models stem from mainly two principles i.e. General Equilibrium Asset Pricing and Rational Pricing theory.

General Equilibrium Asset Pricing theory states that the price of an asset is determined through market forces of Demand and Supply. The models under the said principle determine the prices with reference to Macroeconomic variables - as CAPM models consider the “overall market”. These models aim at modelling the statistically derived probability distribution of the market prices of "all" securities at a given future investment horizon. Whereas, under the Rational pricing theory the price of an Asset is determined by creating the specific risk and return for a specific security.

The Capital Asset Pricing Model (CAPM) suggests that while calculating the optimum/maximum price of an Asset, several factors such as risk associated, risk free rate of return, beta for taking the risk, expected return etcetera should be considered. The goal of such models is to determine whether the Asset is fairly valued when its risk and time value of money are compared to its expected return. However, there are several models such as the Arbitrage Model of pricing which consider economic variables for determining the price such as change in inflation, gross national product, exchange rates.

Even though the Asset pricing models are backed by numerous statistical proofs and various assumptions, one cannot perfectly predict the price of a share with the help of such models. The main reason for failure of these models is the ever changing business environment. One cannot predict the changes which the government is going to announce in the near future and the impact it would have on the value of an asset. Similarly, it is nearly impossible to predict the changes which may take place in the world. There are numerous instances which confirm that markets never remain steady and are very sensitive to changes in the environment. For instance, crude oil futures usually trade at around $20+/BBL but due to COVID-19 pandemic the price of futures of crude oil in the month of April this year became negative. The reason for the same was inability of Crude purchasing companies to take the delivery of crude oil because of lockdown and no movement of people and commodities around the world leaving the market with zero buyers of such future contracts and thus, leading to negative prices.

The question then arises how can one predict the fair price of an asset in order to gain from the market? The answer is simple - financial markets are nothing but a regulated system of betting and no one is ever able to predict the result of betting unless there is some dirty game involved such as insider trading in case of the stock market.

To gain from stocks you need to be constantly in touch with the market and the news revolving around. One needs to be proactive and should not be risk averse. However, if one does not like to take risks then he can invest in zero risk securities in which there is usually less need of putting an emphasis on determining the fair price of an asset. An investor needs to be active enough so that in case the market tends to change owing to some new news, he would be able to gain from the situation. However, there are several famous investors who put more emphasis on holding the stock for a long period of time and thus ignoring the said risk of change in the environment, it just depends on the investor and his risk appetite.

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