Asset Pricing Theory

Asset Pricing Theory explores how the prices of financial assets, like stocks and bonds, are determined. It examines the relationship between risk and expected return — higher risks generally necessitate higher potential returns. Key models, like the Capital Asset Pricing Model (CAPM), suggest that an asset's price reflects its expected return based on its risk compared to a benchmark. This theory helps investors make informed decisions by evaluating whether an asset is fairly valued, overvalued, or undervalued based on its risk and the prevailing market conditions.