#### First Principles of Asset Pricing ###### 1. Asset classes outperform cash over time - An investment is a transfer of liquidity that carries risk. This risk is because you are losing an opportunity to put that liquidity to work tomorrow. - To compensate for this you are offered a **risk premium** over and above what you can earn by keeping your money in cash - **More risk = More compensation required** ###### 2. Asset prices discount future economic scenarios - The Price of any asset reflects the discounted value of the assets's expected cash flows - Expected Cash Flows and Discount Rates incorporate expectations about the future economic environments, such as the level of inflation, earnings growth, default [[probability]]. - Environment & Economic Changes lead to Asset Price changes - Asset Prices incorporate the expectations about economic factors and most importantly growth and inflation --> The aggregate cash flows of an asset class and the rate at which they are discounted are largely dependent on - Growth - Volume of Economic Activity - Inflation - Pricing of that activity - Asset class returns will be largely determined by whether inflation and growth come in lower/higher than discounted, and how discounted growth and inflation change. Drivers of Returns of any assets: - The accrual of and changes to **RISK PREMIUMS** (Point 1) - **UNANTICIPATED ECONOMIC SHIFTS** (Point 2)