Asset prices are the prices of claims on future payoffs (dividends, coupons, rents, resale value). They are determined by expectations about those payoffs and by how markets discount risk and time.
The valuation logic
A simple benchmark is present discounted value:
[ P_t = \sum_{j=1}^{T} \frac{E_t(CF_{t+j})}{(1+r)^{j}}, ]
where (CF_{t+j}) are future cash flows and (r) is a discount rate. In practice, the relevant discount rate is not just “the interest rate.” It includes compensation for risk.
A more general (risk-aware) statement used in finance and macro is the stochastic discount factor (pricing kernel) form:
[ P_t = E_t\big[m_{t+1} X_{t+1}\big], ]
where (X_{t+1}) is next period’s payoff and (m_{t+1}) summarizes how the market values payoffs across states of the world.
What moves asset prices
Asset prices change when markets revise:
- expected cash flows: earnings, default probabilities, rents, growth prospects,
- discount rates: real rates, expected inflation, and term structure components,
- risk premia: how much return investors require for bearing systematic risk,
- liquidity conditions: how costly it is to trade or finance positions.
Macro and policy relevance
Because asset prices affect wealth and collateral, they feed back into the real economy:
- higher asset prices can support consumption (wealth effects),
- higher collateral values can relax borrowing constraints,
- monetary policy changes can move discount rates and risk-taking incentives.
Practical example (bond pricing)
A plain bond’s price is tightly linked to interest rates: when yields rise, the present value of fixed coupons falls, so the bond price typically falls. Longer-maturity bonds are usually more sensitive because more of their value comes from distant cash flows.
Related Terms
- Discount Rate
- Present Discounted Value
- Net Present Value
- Risk Premium
- Term Premium
- Arbitrage
- Efficient Markets Hypothesis
- Liquidity
- Bubble