Background Issues On Asset Pricing

A fundamental result in modern asset pricing theory is that the price of any financial asset corresponds to the present value of its expected future cash-flows, this present value being obtained by applying a positive stochastic discount factor (hereafter sdf, denoted by Mt). If the future cash-flows correspond only to the financial asset price in the next period we have:

Another fundamental result in finance theory is that asset prices and returns are related to their risk, which is the ability of the asset to offer higher cash-flows when they are more needed. In fact, the more an asset helps to smooth income fluctuations, the less risky it is and the higher will be its demand for insuring against "bad times". Employing some simple algebra in equation (3.1), the following equation illustrates this link between asset prices and their risk:

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