Asset Pricing Theory

The recent financial crisis has revealed some limitations of the models of option pricing used in the finance industry. The appropriate reaction to this observation is not to throw away the models but rather to achieve a better understanding of their theoretical underpinnings so as to know when to use which type of model for which purpose.

This course aims at providing such a theoretical and conceptual grounding of asset pricing models with a minimal level of maths (to the extent it is possible in asset pricing) and a focus on the economic interpretation of models.

Course Objectives

Acquire a good comprehension of basic models of option pricing (binomial model and B&S):

  • Assumptions
  • Risk-neutral pricing
  • Assessing the output of the model
  • When to use more advanced models and why

Develop a sensitivity to model risk issues:

  • Mis-specified models
  • Implications of market incompleteness
  • Some common misuse of models

Understand the economic interpretation of key concepts:

  • Risk neutral probability / pricing kernel
  • Implied volatilities / correlations / smile
  • Link with factor pricing
  • Risk-neutral vs. equilibrium pricing.

Course Content

  1. Risk neutral pricing and binomial model
  2. Black and scholes model
  3. Volatility and model risk
  4. Completeness and arbitrage
  5. From arbitrage back to equilibrium pricing