Decoding Stock Prices: What REALLY Drives Markets

This is lesson 9 in my series "The DNA of Wall Street". I cover:
1. No Arbitrage Pricing
2. Equilibrium Pricing
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[@lexot44]

Great video as always! Keep up the good work!

[@vegahedge2635]

Good Videos. In the end you are stating, that with CAPM you can price any financial asset. With CAPM as a one factor model however you can only calibrate an expected return of a stock by explaining the variance of the return with the variance of the market return. This expected return can then be used as a discount factor in a simple DCF Model to value a stock. You will not be able to value non linear derivatives with the CAPM.

[@FinAndEcon]

Thank You. But what you are saying is not true. Going way beyond the scope of this course, the CAPM is a model which specifies a stochastic discount factor. And with that you can price any asset via the standard formula (en.wikipedia.org/wiki/Stochastic_discount_factor). However, because the CAPM does (in part) not work well in reality, no one would ever do that. But I am going to talk about that in length in future videos :).

[@vegahedge2635]

@@FinAndEcon You mean that you will be able to determine the discount factor for any asset, which of course is only one component of the valuation. Furthermore you will need to assume a certain stochastic differntial equation for the diffusion process of the underlying in order to simulate a terminal distribution of the derivatives payoff (under the real physical probability measure instead of the risk-neutral one, which is rarely used in practice for valuation). Then the discount factor can be applied to the Expected Value of the Terminal Payout. But you are right, this probably goes too deep :)

[@FinAndEcon]

@@vegahedge2635 Ok this is a bit nerdy but anyway. The CAPM is a one-period model (at least in the basic version). And the CAPM allows you to price any asset within that one period, assuming mean variance preference among all market participants. This means you are in a discrete world, and you use the CAPM stochastic discount factor and the real probability measure. Of course no one does this in practice, because CAPM assumptions do not yield stable predictions for real world prices. So right, in the real world people use stochastic diffusion processes (or no arbitrage ideas if possible)

[@kerri648]

psychology