Pricing, Risk, and Performance Measurement in Practice

Chapter 10 Understanding Valuation Theory

We present the key principles and elements of modern valuation theory, which is the basis of modern pricing, risk, and performance models. We demonstrate how modern valuation theory allows for building valuation models for virtually any instrument from a manageable set of atomic valuation building blocks described in our approach.

10.1 The Purpose of Valuation Theory

Asset pricing is about finding an appropriate value, or a “price” for a financial instrument, an asset. We use the term valuation theory instead of “asset pricing theory” as it is more generic and also points more in the direction of what the theory actually does.

The theory gives an economic rational for the valuation model, so we can ...