Foundations of Asset Pricing

General Equilibrium Asset Pricing Introduction General equilibrium asset pricing provides a framework for understanding how asset prices are determined across entire markets simultaneously. Rather than pricing individual assets in isolation, this approach recognizes that all assets are priced together in a system where supply and demand must balance for every asset. This theory forms the foundation for many of the pricing models you'll encounter in finance. Market-Clearing Principle CRITICALCOVEREDONEXAM The fundamental principle of general equilibrium theory is that asset prices adjust until the quantity of each asset supplied equals the quantity demanded. In other words, markets must clear. Why does this matter? Consider what happens if an asset is overpriced: more people want to sell than buy, creating excess supply. This imbalance causes the price to fall until enough buyers step in to absorb all available supply. Conversely, if an asset is underpriced, excess demand pushes prices up until supply and demand balance again. The key insight is that this market-clearing process happens simultaneously across all assets in the market. Asset prices are not determined independently—they're determined collectively as part of an interconnected system. When you invest in one asset rather than another, you're making a trade-off, and market prices reflect all of these trade-offs across all investors. This equilibrium price reflects all available information and the collective preferences of market participants. The Role of Macroeconomic Variables NECESSARYBACKGROUNDKNOWLEDGE In general equilibrium asset pricing models, individual investor preferences are not priced separately. Instead, they're aggregated into broader market factors. Rather than the model explicitly accounting for each person's unique risk tolerance, time horizon, or consumption preferences, these preferences are reflected in a few key aggregate variables that drive overall market returns. This aggregation is crucial because it makes the models tractable. Instead of modeling millions of individual investors with different preferences, we can capture the essential dynamics with a smaller number of market-wide factors. The required rate of return for an asset—the discount rate you'll use in valuation—comes from an equilibrium model that reflects these aggregated market conditions. Discounted Cash-Flow Valuation Process CRITICALCOVEREDONEXAM Once we understand how required returns are determined through equilibrium pricing, we can value an asset using a three-step discounted cash-flow (DCF) process: Step One: Forecast Future Cash Flows Begin by estimating all cash flows that the asset (or business) will generate in the future. This might include dividends for a stock, coupon and principal payments for a bond, or free cash flows for a firm. These forecasts should be based on your best estimates of the business's operations, growth, and performance. Step Two: Determine the Discount Rate The discount rate you use is the required rate of return, determined from your chosen equilibrium pricing model. Importantly, this rate should reflect the undiversifiable risk of the asset. Undiversifiable risk (also called systematic risk) is the portion of an asset's risk that cannot be eliminated through diversification—it's the risk that moves with the overall market. Assets with higher undiversifiable risk require higher expected returns as compensation for that risk. This is why the equilibrium model matters: it tells you what discount rate is appropriate given the asset's risk. An asset with no undiversifiable risk might require only the risk-free rate, while a highly risky asset requires a much higher rate. Step Three: Calculate Present Value For each forecasted cash flow, calculate its present value by discounting it back to today using the required rate of return: $$PV = \frac{CF1}{(1+r)^1} + \frac{CF2}{(1+r)^2} + \frac{CF3}{(1+r)^3} + \cdots$$ where $CFt$ is the cash flow in year $t$ and $r$ is the required rate of return. The total asset value is the sum of all these discounted cash flows. The economic logic here is straightforward: money today is worth more than money tomorrow because you can invest it and earn returns. The discount rate captures both the time value of money and compensation for the risk you're bearing by investing in this asset. <extrainfo> Fundamental Valuation Alternatives An alternative to DCF valuation is the T-model approach, which relies on accounting information to estimate expected returns rather than explicitly forecasting cash flows. While less commonly used than DCF, this approach can be useful when detailed cash flow forecasts are difficult to produce. The T-model expresses expected returns as a function of accounting variables like earnings growth, dividend payout ratios, and book value metrics. </extrainfo>