I think the question has already been asked about stylized facts of asset returns; this question regards the essential characteristics and normative assumptions used to evaluate asset prices. I.e., given that the economic value of a generic asset is its discounted expected utility, what are some assumptions by which an economic stakeholder may assess a claim's worth?
To start, here are a few:
- Price is an expressed belief of value.
- The efficient market hypothesis (EMH): the market acts as a price discovery mechanism in which market prices reflect participants' capital-weighted expectation. It should be difficult to prove that the market price is not "correct". "Price is what you pay -- value is what you get" applies only in cases where the market is not efficient.
- The fundamental theorem of asset pricing (FTAP) which posits (i) a risk-neutral measure equal to a probabilistic measure which can only be rigorously demonstrated given (ii) complete markets.
- FTAP's correlary to EMH: in an efficient market place, any price which reflects a $\mathbb P$ (i.e., "acturial" and/or "real-world") expectation that does not have a different $\mathbb Q$ ("risk-neutral") measure can be considered an efficient price. I.e., any "no-arbitrage" price is permitted under EMH.
- Asset prices cannot be negative (or can they???). Since maximum loss is (typically) constrained to principal invested, asset prices cannot theoretically be negative -- but, in practice, investors may assign them negative values (vis-a-vis, the "drag" on value whereby the inclusion of an asset causes a portfolio to be valued less than it if were dis-included).
- Corollary of requirement that prices be supported over the domain $\left[0, \infty \right]$: price paid determines both expected return as well as maximum loss (à la Seth Klarman's synthesis regarding Warren Buffet-esque "Margin of Safety").
- The fair price of any generic asset is equal to the expected net present value of the discounted cash flows that it is expected to generate.
- Time value of money (TVM): Time is money. Time has monetary value which can be expressed as a utility function. Utility is usually interchangeably expressed as a discount factor or an interest rate which represents an expected and/or required rate of return based on an investor's intertemporal preferences regarding consumption and risk. Rational utility should always be a monotonically decreasing utility function with respect to time -- i.e.,"a dollar today is always worth more than a dollar at any time in the future". Therefore, discount rates cannot be negative (or can they???). Also, a discounting function need not be an exponential/geometric (i.e., normative) function, continuous, symmetrical, or time-invariant.
- Modigliani-Miller's postulates on (i) the value of a firm and (ii) the irrelevance of capital structure inform the intuition that -- under a broad range of regulatory frameworks -- capital structuring decisions are not a major factor in determining an asset's enterprise value.
- Corollary to MM II: it is simpler to price the firm's underlying assets in totality (and then allocate value to claims in order of seniority) vice value each class of claim individually, vis-a-vis "in order to value a company's stock, one must first value the company itself" (attribution needed).
- Arbitrage Theory of Pricing's (APT) statement that asset prices are reflexively a transformed function of returns.
- The Capital Asset Pricing Model's (CAPM) application of APT which states that asset prices are a function of diversifiable and non-systemic risk under a mean-variance framework.
- Equity is analogous to a long call option on a firm's value; debt is analogous to short put option on a firm's value. A position which is long equity and long debt is a synthetic long position on the firm's underlying assets.
Good responses should add depth to and/or expand upon those characteristics already identified. I also would appreciate any relevant references including compendia and/or primers.
I appreciate your thoughts and references.
