Risk Analysis

The Capital Asset Pricing Model: CAPM

Prof. Lei Lian

Teaching Notes # 10 & 11 Financial Risk Management

October 17, 2013

Lei Lian (Isenberg)

The Capital Asset Pricing Model: CAPM

October 17, 2013

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Outline

Introduction Assumptions The Market Portfolio The Capital Market Line The Security Market Line Conclusions

Lei Lian (Isenberg)

The Capital Asset Pricing Model: CAPM

October 17, 2013

2 / 37

Introduction: Portfolio Section vs. the CAPM

So far, we have looked at the problem of how to select a portfolio, given that we know what the expected returns and return covariances are. However, we don’t yet know where to get estimates of these data. Particularly since expected returns are very hard to measure, one thing that would be useful, but which we don’t yet have, is a model of what returns should be. The CAPM is an equilibrium model of the relation between the expected rate of return and the return covariances for all assets.

Lei Lian (Isenberg)

The Capital Asset Pricing Model: CAPM

October 17, 2013

3 / 37

Equilibrium

A situation where no investor wants to do anything differently We will need this concept to come up with a pricing model. Note that the mean-variance portfolio problem is relevant for each investor, regardless of whether the equilibrium argument, and the CAPM, is correct or not.

Lei Lian (Isenberg)

The Capital Asset Pricing Model: CAPM

October 17, 2013

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Equilibrium in Financial Markets

If everyone in the economy holds an efficient portfolio, then how should securities be priced so that they are actually bought 100% in equilibrium? For example:

If based on the prices/expected returns, we found that IBM would never enter any maximizing investor’s portfolio (long), then something is wrong. IBM would be priced too high (offer too low an expected rate of return). The price of IBM would have to fall to the point where, in aggregate, investors want to hold exactly the number...