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Rational Pricing

Definition

Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.

What is 'Rational Pricing'

A financial theory that contends that the market prices of assets will represent the arbitrage-free pricing level for those assets. This is based on the assumption that any deviation from arbitrage-free price levels for an asset will result in arbitrageurs immediately trading away the profit opportunity on the asset until it trades at an arbitrage-free price.

Explaining 'Rational Pricing'

A typical example of where the theory of rational pricing would be expected to come into play would be two identical assets trading in different markets. If the asset traded at a lower price in one market, an arbitrage trader would attempt to make a risk-free profit by purchasing the asset in the cheaper market by short selling the asset in the more expensive market. With enough volume, this arbitrage trading would cause the prices in both markets to converge to an equal value, removing the arbitrage opportunity.


Further Reading


Rational pricing of internet companies
www.tandfonline.com [PDF]
… To estimate the two market prices of risk, we used as the standard deviation for aggregate wealth 5 percent per quarter (or 10 percent per year) … 0 Price ($) 5/97 11/99 8/97 11/97 5/98 8/98 11/98 2/99 2/98 5/99 8/99 Page 8. Rational Pricing of Internet Companies May/June 2000 …

Rational herding in financial economicsRational herding in financial economics
www.sciencedirect.com [PDF]
… To estimate the two market prices of risk, we used as the standard deviation for aggregate wealth 5 percent per quarter (or 10 percent per year) … 0 Price ($) 5/97 11/99 8/97 11/97 5/98 8/98 11/98 2/99 2/98 5/99 8/99 Page 8. Rational Pricing of Internet Companies May/June 2000 …

Implications of data restrictions on performance measurement and tests of rational pricingImplications of data restrictions on performance measurement and tests of rational pricing
papers.ssrn.com [PDF]
… To estimate the two market prices of risk, we used as the standard deviation for aggregate wealth 5 percent per quarter (or 10 percent per year) … 0 Price ($) 5/97 11/99 8/97 11/97 5/98 8/98 11/98 2/99 2/98 5/99 8/99 Page 8. Rational Pricing of Internet Companies May/June 2000 …

Bubbles, rational expectations and financial marketsBubbles, rational expectations and financial markets
www.nber.org [PDF]
… To estimate the two market prices of risk, we used as the standard deviation for aggregate wealth 5 percent per quarter (or 10 percent per year) … 0 Price ($) 5/97 11/99 8/97 11/97 5/98 8/98 11/98 2/99 2/98 5/99 8/99 Page 8. Rational Pricing of Internet Companies May/June 2000 …

Rational pricing of water as an instrument of improving water use efficiency in the agricultural sector: a case study in Gujarat, IndiaRational pricing of water as an instrument of improving water use efficiency in the agricultural sector: a case study in Gujarat, India
www.tandfonline.com [PDF]
… To estimate the two market prices of risk, we used as the standard deviation for aggregate wealth 5 percent per quarter (or 10 percent per year) … 0 Price ($) 5/97 11/99 8/97 11/97 5/98 8/98 11/98 2/99 2/98 5/99 8/99 Page 8. Rational Pricing of Internet Companies May/June 2000 …

Rational asset pricesRational asset prices
onlinelibrary.wiley.com [PDF]
… To estimate the two market prices of risk, we used as the standard deviation for aggregate wealth 5 percent per quarter (or 10 percent per year) … 0 Price ($) 5/97 11/99 8/97 11/97 5/98 8/98 11/98 2/99 2/98 5/99 8/99 Page 8. Rational Pricing of Internet Companies May/June 2000 …

Behavioral rationality in finance: The case of dividendsBehavioral rationality in finance: The case of dividends
www.jstor.org [PDF]
… To estimate the two market prices of risk, we used as the standard deviation for aggregate wealth 5 percent per quarter (or 10 percent per year) … 0 Price ($) 5/97 11/99 8/97 11/97 5/98 8/98 11/98 2/99 2/98 5/99 8/99 Page 8. Rational Pricing of Internet Companies May/June 2000 …

Behaviorial finance: Past battles and future engagementsBehaviorial finance: Past battles and future engagements
www.tandfonline.com [PDF]
… To estimate the two market prices of risk, we used as the standard deviation for aggregate wealth 5 percent per quarter (or 10 percent per year) … 0 Price ($) 5/97 11/99 8/97 11/97 5/98 8/98 11/98 2/99 2/98 5/99 8/99 Page 8. Rational Pricing of Internet Companies May/June 2000 …



Q&A About Rational Pricing


What do investment theories encompass?

Investment theories encompass the body of knowledge used to support decision-making processes for choosing investments and the asset pricing models are then applied in determining the required rate of return on the investment in question or in pricing derivatives on these for trading or hedging.

What is rational pricing?

Rational pricing is a financial theory that contends that the market prices of assets will represent the arbitrage-free pricing level for those assets.

What is an asset pricing model?

An asset pricing model is a formal treatment and development of two main principles, outlined below, together with the resultant models.

How does rational pricing work in practice?

Arbitrageurs would attempt to make risk-free profits by purchasing an asset in a cheaper market and short selling it in a more expensive market. With enough volume, this arbitrage trading would cause the prices in both markets to converge to an equal value, removing the arbitrage opportunity.

How are prices determined under general equilibrium theory?

Prices are determined through market price by supply and demand.

Is rational pricing based on assumptions or actual observations?

Rational Pricing is based on assumptions.

What are two examples of where rational pricing might come into play?

Two identical assets trading at different prices or one asset traded at a lower price than another.

What does rational pricing entail?

Rational pricing entails rational asset pricing.

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