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Investment theory, which is near synonymous, encompasses the body of knowledge used to support the decision-making process of choosing ,William N. Goetzmann (2000). An Introduction to Investment Theory (Digital textbook). Yale School of Management. William F. Sharpe (1999). Macro-Investment Analysis (Digital textbook). Stanford University and the asset pricing models are then applied in determining the asset-specific required rate of return on the investment in question, and for hedging.
These models aim at modeling the statistically derived probability distribution of the market prices of "all" securities at a given future investment horizon; they are thus of "large dimension". See under Mathematical finance. General equilibrium pricing is then used when evaluating diverse portfolios, creating one asset price for many assets.
Calculating an investment or share value here, entails: (i) a financial forecast for the business or project in question; (ii) where the output cashflows are then present value at the rate returned by the model selected; this rate in turn reflecting the "riskiness" - i.e. the idiosyncratic, or Systematic risk - of these cashflows; (iii) these present values are then aggregated, returning the value in question. See: , and Valuation using discounted cash flows. (Note that an alternate, although less common approach, is to apply a "fundamental valuation" method, such as the T-model, which instead relies on accounting information, attempting to model return based on the company's expected financial performance.)
In general this approach does not group assets but rather creates a unique risk price for each asset; these models are then of "low dimension". For further discussion, see under Mathematical finance.
Calculating option prices, and their "Greeks", i.e. sensitivities, combines: (i) a model of the underlying price behavior, or "process" - i.e. the asset pricing model selected, with its parameters having been calibrated to observed prices; and (ii) a numerical method which returns the premium (or sensitivity) as the expected value of option payoffs over the range of prices of the underlying. See .
The classical model here is Black–Scholes which describes the dynamics of a market including derivatives (with its option pricing formula); leading more generally to martingale pricing, as well as the above listed models. Black–Scholes assumes a log-normal process; the other models will, for example, incorporate features such as mean reversion, or will be "volatility surface aware", applying local volatility or stochastic volatility.
Rational pricing is also applied to fixed income instruments such as bonds (that consist of just one asset), as well as to interest rate modeling in general, where yield curves must be arbitrage free with respect to the prices of individual instruments. See , Bootstrapping (finance), and Multi-curve framework. For discussion as to how the models listed above are applied to options on these instruments, and other interest rate derivatives, see short-rate model and Heath–Jarrow–Morton framework.
Relatedly, both approaches are consistent Mark Rubinstein (2005). "Great Moments in Financial Economics: IV. The Fundamental Theorem Part I", Journal of Investment Management, Vol. 3, No. 4, Fourth Quarter 2005;
~ (2006). Part II, Vol. 4, No. 1, First Quarter 2006. with what is called the Arrow–Debreu theory.
Here models can be derived as a function of "state prices" - contracts that pay one unit of a numeraire (a currency or a commodity) if a particular state occurs at a particular time, and zero otherwise. The approach taken is to recognize that since the price of a security can be returned as a linear combination of its state prices (contingent claim analysis) so, conversely, pricing- or return-models can be backed-out, given state prices.
Edwin H. Neave and Frank Fabozzi (2012). Introduction to Contingent Claims Analysis, in Encyclopedia of Financial Models, Frank Fabozzi ed. Wiley (2012)
Bhupinder Bahra (1997). Risk-neutral probability density functions from option prices: theory and application, Bank of England
The CAPM, for example, can be derived by linking risk aversion to overall market return, and restating for price. Black-Scholes can be derived by attaching a binomial probability to each of numerous possible spot price (i.e. states) and then rearranging for the terms in its formula.
See .
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