Financial Economics

Principles of Asset Pricing

Universidad del Rosario

September 17, 2020

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 Motivation

Financial decision without imposing strong assumptions on

preferences: risk aversion, mean-variance preferences.
Example of an arbitrage: non financial assets and financial assets.
Arbitrage based principles. Regardless of preferences investors are
optimizers and look for a ”free lunch” (get something for nothing).
In well functioning markets there should be no free lunch(es) hence
pricing of financial assets is bases on no-arbitrage.
Recall the most general pricing principal, p = f (payoffs). Examples
with no uncertainty: present value and bonds.

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 Requirements, algebra

Two period problem t ∈ 0, 1, K assets and S states. We know about

values and prices at t = 0 and we have a discrete distribution of outcomes
at t = 1. Payoffs on the assets can be represented by a SxK matrix,
 
A1,1 . . . A1,K
A =  ... .. .. 

. . 
AS,1 ... AS,K

Price of the assets can be represented as a KX 1 vector q 0 = [q1 , . . . , qK ].

Let returns be defined as element by element operations,
As,k
Gross Returns: Rs,k = qk .
Net Returns: rs,k = Rs,k − 1

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 Definitions

Financial Market: is a pair (A, q) payoff matrix and price vector.

Universe of assets.
Portfolio (units/shares): is a Kx1 vector of allocations,
θ0 = [θ1 , . . . , θK ]. Allocations as weights can be estimated as element by
element operation wk = θθk0qqk .
Payoff of Portafolio: A (SX 1) vector denoted as V = Aθ that indicates
the gains/losses in any state.
Price of a portfolio: q 0 θ

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 Exercise, comparing Payoff Matrices

Compare the following payoff matrices

 
2 1 −2
2 −1 0
A= 2 3

5
2 10 −4
 
1 0 0
B = 0 3 0
0 0 1
What can you conclude about the behavior of assets in these financial
markets?

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 Exercise, Payoff of a portfolio

Compare the following payoff matrices

 
2 1 −2
2 −1 0
A= 2 3

5
2 10 −4

where the vector of allocations is θ = (−1, 3, 2) and q = (1, 3, 5) denote

the vector of prices for the assets.
1 Estimate the payoff of the portfolio in every state.
2 Estimate the price of the portfolio.
3 Estimate the portfolio shares of each asset.

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 Concepts

A Replicating portfolio: φ is a replicating portfolio of θ if for a payoff

matrix A, Aθ = Aφ such that θ 6= φ.
Redundant asset: Asset k is redundant if its payoff can be replicated by
a portfolio of other assets.
For example asset 3 is a redundant asset,
 
1 0 3
A=
0 1 7

There exist a portfolio (3, 7, 0) such that asset 1 and 2 replicate the
payoff of asset 3.
Redundant asset exist if the columns of payoff matrix are linearly
dependent.

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 Standard basis and non-redundant payoff matrices

The payoff matrix determined by the standard basis in a vector space

provides a space of assets that is non-redundant,
 
..
1 . 0
AA = 
 
. .
 .. . . . .. 
0 ... 1

In financial economics these asset (identity matrix) are called State

claims or Arrow-Debreu securities, they act as a form of insurance.

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 Complete Market

A financial market (A, q) is considered complete if any payoff vector V

can be attained. Aθ = V
Portafolio θ needs to satisfy the budget constraint of the investors.
Market completeness is not realistic but allows to obtain unique
asset pricing.
We have incomplete markets if some payoff are not attainable.

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 Example 1: Incomplete markets

 
1 0
A = 0 1
0 0
None of the assets pays anything in state 3 therefore the value of the
portfolio is restricted in that state.

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 Example 2: Incomplete markets

 
1 0
A = 0 1
1 1
Restricted to portfolio where V3 = V1 + V2 .

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 Example 2: Incomplete markets

 
1 0 1 4
A = 0 1 1 −3
1 1 2 1
Redundant assets A1 + A2 = A3

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 Payoff matrix and Completeness

The rank(A) of a payoff matrix SXK is the number of linear independent

columns or rows. rank(A) ≤ min(S, K ).
Markets with assets less than the number of states cannot be complete
therefore rank(A) ≤ K < S ⇒ rank(A) = S.
Suppose that you have a symmetric payoff matrix A, that is SXS with
linear independent rows so it is of full rank. If you are given the payoff
matrix and a portfolio payoff, then since the market is complete you can
always find a portfolio that is able to replicate the payoff.

Aθ = V ⇒ θ̂ = A−1 V

The allocation is the solution to the previous system.

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 Law of One Price (LOOP)

For a financial market (A, q) the law of one price holds if given two
portfolios θ and φ, if the payoff of the portfolio is the same then the price
of the portfolio should be the same

Aθ = Aφ ⇒ q 0 θ = q 0 φ

LOOP exist if there are no redundant assets,

Aθ = Aφ ⇒ (θ − φ)A = 0

If A is of full rank then by the definition of linear independence of the

columns of the matrix then the only solution to the equation
(θ − φ)A = 0 is that θ = φ and hence the price of the portfolio is the
same.

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 State prices and claims

Remember AA as the matrix of contingent claim payoffs. There is only

one assets that pays (1) at each state.
State prices: Is the price of the state claim of state s. The vector of
state prices (SX 1), π 0 = (π1 , . . . , πS ). These state prices denote the
price of these fundamental assets (standard basis).
In a financial market (AA , π) we can express any price of a security k as
the weighted average of state prices.
S
X
qk = π1 A1,k + . . . + πS AS,k = πs As,k
s=1

The vector of all prices for the K securities, q = A0 π.. Given q and A the
characterization of a financial market, you can solve the system of
equations to find π.

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 Pricing using risk neutral probabilities

Introduce a risk free asset, whose payoff it the same for every state
(Ak = Arf ∀s).
XS
qk = Arf πs
s=1

Let Rr = 1 + rf denote the gross return and net return of the risk free
asset. Divide previous expression by qk then
S S
Arf X X
1= πs = (1 + rf ) πs
qk s=1 s=1

Then 1 + rf = PS 1 .
s=1 πs

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 Pricing using risk neutral probabilities
S
X
qk = πs As,k
s=1
PS
Divided by 1 = (1 + rf ) s=1 πs
PS S
πs As,k 1 X
qk = s=1
PS = As,k πs∗
(1 + rf ) s=1 πs
(1 + rf ) s=1

where πs∗ = PSπs is relative price of each state with respect to the
s=1 πs
price of other. Note that πs∗ ∈ (0, 1) is a probability. Then

1
qk = Eπ∗ (Ak )
(1 + rf )

Price of any asset k is expected value of the discounted payoffs. This is

risk neutral pricing.

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 Pricing Principles

Under regular pricing the state prices reflect individual preferences.

Under risk neutral pricing all investors are risk neutral (modified
their odds or values at each state).
Under risk neutral pricing the discount factor is the risk free rate.

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 Exercise

Suppose the following payoff matrix

 
10 20 30
A = 10 10 10
10 5 5

where the vector of state prices is θ = (0.25, 0.3, 0.4).

1 Using the given state prices, find the price vector q of all the assets.
2 What is the net rate of return on the risk free asset rf .
3 Calculate the risk neutral probabilities and use them together with
the risk free return rate to find the asset price vector q.

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 Arbitrage oportunity

Arbitrage opportunity: There exist a portfolio θ,

q 0 θ ≤ 0; Aθ ≥ 0

Negative price (short) at time 0 and a positive value V > 0 at time 1.

This is a free lunch. A financial market (A, q) if such a portfolio does not
exist.
Note: If there is no arbitrage opportunities ⇒ LOOP holds.

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 Fundamental Theorem of Asset Pricing

No arbitrage opportunities.
Exist a strictly positive state price vector π > 0 such that q = A0 π.
There exist an investor with monotone preference whose utility is
maximized over the state space of payoffs U(V1 , . . . , VS ), where
Aq = V .

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