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Capital Asset Pricing Model
This model explains the association between systematic risk and the asset's expected return. The capital asset pricing model is extensively used in pricing risky financial securities. It also helps in the generation of the returns expected on assets based on the risks involved and the cost of capital. All investors expect compensation for the time value of money and venturing into a risk. The time value of money is accounted for by the risk-free rate in the capital asset pricing model formula.
Equivalent Martingale Measures
This is a probability measure used in pricing derivatives and other financial security. It is sometimes referred to as risk-neutral measures. The martingale measure provides investors with deep mathematical insights into the risks in the market that are associated with a given asset. To accurately estimate the price of an asset, all the risks that are associated with the asset must be taken into consideration.
Utility Indifference Pricing
This pricing paradigm is founded on the notion of utility indifference. This theory was first curated by Tony Neuberger and Stewart Hodges in 1989. Since then, utility indifference pricing has been expanded especially in the academic domain. This approach is widely used in the pricing of financial assets in incomplete markets. These markets have insufficient traded assets that can build a replica of the portfolio. As a result, traditional risk-neutral valuation is bound to fail.