Absence of arbitrage establishes relations among

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Absence of arbitrage establishes relations among security prices. Definition : Pricing relations by arbitrage are called arbitrage pricing . I Arbitrage pricing only prices one security off other securities. I Arbitrage pricing does not determine all security prices. I Arbitrage pricing is key for most corporate finance decisions. Key Assumptions of Arbitrage Pricing : 1. More is better than less (a weak assumption). 2. No frictions, such as trading costs short sales constraints. c Jiang Wang Fall 2003 15.407 Lecture Notes
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Introduction to Part B – Valuation Second Pricing Principle : Supply equals demand — market in equilibrium. Market equilibrium determines security prices in terms of “funda- mentals” Expectation of future cash flows Risk in future cash flows Investors’ preferences toward risk . . . Definition : Pricing relations by equilibrium are called equilibrium pricing . Example. CAPM. Note: I Equilibrium pricing allows us to price securities based on fun- damentals. I Equilibrium pricing determines all security prices. I Equilibrium pricing is key to understanding economic forces behind security prices (e.g. expectations, risk, preferences). Readings: BKM Chapter 2, 3. Readings package: “Stocks in trade” (Economists). 15.407 Lecture Notes Fall 2003 c Jiang Wang
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