ABSTRACT

Asset pricing models try to explain how prices are set in asset markets and how these prices relate to the risk of asset cash flows. To achieve this, asset pricing models start from assumptions about investors and the market structure, and derive conditions that asset prices must fulfil in market equilibrium. The positive role of asset pricing models is to describe and help us to understand how investors behave in actual asset markets. Some early models are useful as long as only intuition is needed, whereas newer and refined models usually better explain asset prices. Asset pricing models can also differ with respect to the degree of realism they allow. Asset pricing models characterise market clearing – equilibrium – prices. At these prices, the total demand for each asset equals its supply. The pricing formula shows that asset prices should be positively related to their diversification potential.