Principles of Asset Pricing

Asset pricing can be studied in two different settings: absolute pricing and relative pricing. Absolute pricing tries to explain the prices in terms of fundamental macroeconomic variables, applying utility functions and preferences. Relative pricing tries to explain the prices of a group of assets given the prices of a more fundamental group of assets. This chapter discusses absolute pricing with the help of coin tossing games. These examples show that utility functions can be useful in determining reasonable prices. The chapter studies general principles of pricing heuristically, discussing such concepts as absolute and relative pricing, arbitrage, the law of one price, and completeness of models. It describes the basic mathematical terminology and fundamental theorems of asset pricing in discrete time models. The chapter also discusses methods for the comparison of different pricing and hedging methods.