How Is Risk Priced in the Financial Market
How is risk priced in the financial markets? What are the shortcomings of the explanations that finance theory offers for this?
Introduction
The valuation of assets in the financial market is no doubt a challenging task as it is closely correlated with risks and uncertainties embodied in the assets which provide the possibility that the investment outcomes would differ from the expected value (Grundy and Malkiel, 1995). In other words, the valuation of assets is actually linked to the qualification of risk-return trade-off. Up until the introduction of Capital Asset Pricing Model (CAPM) in 1964, the estimation of risk was largely based on the historical performances of individual security rather than a precise geometric or mathematic relationship. Therefore, this essay would contribute a lot to the discussions on CAPM and the Arbitrage Pricing Model as well as their comparison.
Theoretical Background
One fundamental theory behind CAPM and other asset pricing models is the portfolio selection theory which is contributable to Markowitz (1959), Tobin (1959 and 1966). Markowitz points out that under mean-variance criterion, the optimal portfolio should be the set of securities that provide the preferable expected rate of return with the minimum volatility. In addition to this theory, James Tobin proposed that every investor has his own individual preference for liquidity which can be achieved by the combination of the efficient risky portfolio presented by Markowitz and a set of risk-free investment. At the same time, the implement of expected utility hypothesis by John von Neumann and Oskar Morgenstern and the concept of risk adverse have remarkable impact of risk pricing models as well.
Capital Asset Pricing Model
Enlighted by the previous foudations by Markowitz and Tobin, a general equilibrium capital asset pricing model was developed by Sharp(1964), Linster(1965) and Mossin independantly. With a series of assumptions (attached in appendix), the CAPM
Introduction
The valuation of assets in the financial market is no doubt a challenging task as it is closely correlated with risks and uncertainties embodied in the assets which provide the possibility that the investment outcomes would differ from the expected value (Grundy and Malkiel, 1995). In other words, the valuation of assets is actually linked to the qualification of risk-return trade-off. Up until the introduction of Capital Asset Pricing Model (CAPM) in 1964, the estimation of risk was largely based on the historical performances of individual security rather than a precise geometric or mathematic relationship. Therefore, this essay would contribute a lot to the discussions on CAPM and the Arbitrage Pricing Model as well as their comparison.
Theoretical Background
One fundamental theory behind CAPM and other asset pricing models is the portfolio selection theory which is contributable to Markowitz (1959), Tobin (1959 and 1966). Markowitz points out that under mean-variance criterion, the optimal portfolio should be the set of securities that provide the preferable expected rate of return with the minimum volatility. In addition to this theory, James Tobin proposed that every investor has his own individual preference for liquidity which can be achieved by the combination of the efficient risky portfolio presented by Markowitz and a set of risk-free investment. At the same time, the implement of expected utility hypothesis by John von Neumann and Oskar Morgenstern and the concept of risk adverse have remarkable impact of risk pricing models as well.
Capital Asset Pricing Model
Enlighted by the previous foudations by Markowitz and Tobin, a general equilibrium capital asset pricing model was developed by Sharp(1964), Linster(1965) and Mossin independantly. With a series of assumptions (attached in appendix), the CAPM
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