You are here

Asset pricing

4 May, 2015 - 12:29

Once the expected/required rate of return, E(R_i), is calculated using CAPM, we can compare this required rate of return to the asset's estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment. To make this comparison, you need an independent estimate of the return outlook for the security based on either fundamental or technical analysis techniques, including P/E, M/B etc.

Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is the same as the present value of future cash flows of the asset, discounted at the rate suggested by CAPM. If the estimated price is higher than the CAPM valuation, then the asset is undervalued (and overvalued when the estimated price is below the CAPM valuation) 1. When the asset does not lie on the SML, this could also suggest mis-pricing. Since the expected return of the asset at time t is E(R_t)=\frac{E(P_{t+1})-P_t}{P_t} , a higher expected return than what CAPM suggests indicates that P_t  is too low (the asset is currently undervalued), assuming that at time  t+1 the asset returns to the CAPM suggested price 2.

The asset price P_0 using CAPM, sometimes called the certainty equivalent pricing formula, is a linear relationship given by

P_0 = \frac{1}{1 + R_f} \left[E(P_T) - \frac{\mathrm{Cov}(P_T,R_M)(E(R_M) - R_f)}{\mathrm{Var}(R_M)}\right]

where P_T is the payoff of the asset or portfolio 3.