Modeling asset prices

James E. Gentle and Wolfgang Härdle

No 2010-031, SFB 649 Discussion Papers from Humboldt University Berlin, Collaborative Research Center 649: Economic Risk

Abstract: As an asset is traded, its varying prices trace out an interesting time series. The price, at least in a general way, reflects some underlying value of the asset. For most basic assets, realistic models of value must involve many variables relating not only to the individual asset, but also to the asset class, the industrial sector(s) of the asset, and both the local economy and the general global economic conditions. Rather than attempting to model the value, we will confine our interest to modeling the price. The underlying assumption is that the price at which an asset trades is a 'fair market price' that reflects the actual value of the asset. Our initial interest is in models of the price of a basic asset, that is, not the price of a derivative asset. Usually instead of the price itself, we consider the relative change in price, that is, the rate of return, over some interval of time. The purpose of asset pricing models is not for prediction of future prices; rather the purpose is to provide a description of the stochastic behavior of prices. Models of price changes have a number of uses, including, for investors, optimal construction of portfolios of assets and, for market regulators, maintaining a fair and orderly market. A major motivation for developing models of price changes of given assets is to use those models to develop models of fair value of derivative assets that depend on the given assets.

Keywords: Discrete time series models; continuous time diffusion models; models with jumps; stochastic volatility; GARCH (search for similar items in EconPapers)
JEL-codes: C15 (search for similar items in EconPapers)
Date: 2010
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