Lecture Overview:

• Capital Asset Pricing Model - “CAPM”

Asset Pricing in Equilibrium

• The asset price today is the PV of all future cash flows:

$$ P_0=\sum_{t=1}^\infin\frac{E(CF_t)}{(1+E(r))^t} $$

• Asset pricing models are to explain $E(r)$
• Or more precisely, only the risk premium $E(R)-E()-r_f$
• Provides a theoretical $E(r)$ as benchmark for investment decisions.

Equilibrium = market supply & demand on an asset balance each other

• A stable market price to buy and sell.

Forms of Mispricing Overpriced

• P too high, and $E(r)$ is too low.
• Sell until the price drops back to equilibrium price.

Underpriced

• P is too low, and $E(r)$ is too high.
• Buy until the price increases back to equilibrium price.