Question

Answer each of the following:

a) Explain the three possible price dynamics for asset prices, including graphical representations in your answer.

b) Which one would best describe the dynamics of the housing market? Explain your reasoning.

Answer 1

Asset pricing refers to a formal treatment and development of two main pricing principles.

There have been many models developed for different situations.Among those;

General equilibrium asset pricing

rational asset pricing

General equilibrium asset pricing- Under this theory priced are determined through market pricing by supply and demand.

Asset prices jointly satisfy the requirement that the quantities of each asset supplied and quantities demanded must be equal at that price-so called market cleaning.

Genet equilibrium pricing is used when evaluating diverse portfolios, creating one asset price for many assets.

Rational Pricing- Under this theory derivative priced are calculated such that they are arbitrage free with respect to more fundamental securities prices.

In general this approach does not group assets but rather created a unique risk price for each asset, these models are of low dimension.

It is also applied to fixed income, instruments such as bonds( This is also an asset)

Arbitrage free pricing approach-This is for bonds specifically. This method refers to the method of valuing a coupon bearing financial instruments by discounting it future cash flows by multiple discount rates.

By this method, a more accurate price can be obtained.Arbitrage free pricing is used for bond valuation and to detect arbitrage opportunities for investors