Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

What is a key difference between a relative pricing model and an absolute pricing model?

1. Relative pricing models focus only on historical prices

2. Absolute pricing models do not account for economic factors

3. Relative pricing models prescribe the relationship between two prices

4. Absolute pricing models are based on subjective valuations

The correct answer is: Relative pricing models prescribe the relationship between two prices

A key difference between relative and absolute pricing models lies in the foundational principles that govern how assets are valued. Relative pricing models are designed to evaluate an asset's price in relation to other assets or benchmarks, focusing on the relationship between two prices. This approach often employs comparisons, such as price-to-earnings ratios or other multiples, to assess whether an asset is under- or over-valued relative to its peers or market averages. In contrast, absolute pricing models establish a value based on intrinsic factors such as cash flows, discount rates, and future earnings projections without directly comparing the asset to others. This means that absolute pricing models assess the standalone worth of an investment based on its unique characteristics rather than its position relative to other investments. This distinction is crucial for investors and analysts, as it informs their investment strategies and helps them decide when to buy, hold, or sell an asset based on relative value versus theoretical worth.