Pricing an Asset
Written by admin on May 16th, 2011Pricing an Asset
If there should be a momentary disequilibrium such that the price of an asset were “too high,” causing expected returns to be “too low,” investors would sell the asset and its price would return to the equilibrium level. And, the converse would be true for assets whose prices were “too low” and whose expected returns were consequently “too high.” The attractions of a religion based upon faith in Sharpe’s model are obvious. There is absolutely an understandable predisposition to be a “believer.”
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Yet one is obviously naturally deterred initially by the lack of realism of the assumptions underlying the model. There are two ways to assess the practical implications of this lack of realism. One is to examine the assumptions themselves to see whether their apparent absurdity or lack of realism is as great as seems true at first glance. Another approach is to ignore the realism of the assumptions and to see whether predictions based upon the model are confirmed by experience. Fortunately, it is now generally understood that the value of a model lies in its predictive or explanatory power and that the model cannot be judged by reference to the realism of its underlying assumptions. This point has been expressed with great clarity and persuasiveness by Milton Friedman in a famous essay:
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Therefore, we shall pause only briefly to comment on the realism of the underlying assumptions before passing to the more important task of determining the explanatory or predictive power of the model.
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