EquilibriumassetpricingTheCapitalAssetPricingModel.-.PDF

The Capital Asset Pricing Model (CAPM) Professor Lasse H. Pedersen Prof. Lasse H. Pedersen 1 Outline ? Key questions: – What is the equilibrium required return, E(R), of a stock? – What is the equilibrium price of a stock? –Which portfolios should investors hold in equilibrium? ? Answer: CAPM – Assumptions – Results: ?Identify the tangency portfolio in equilibrium ?Hence, identify investors’ portfolios ?Derive equilibrium returns (and hence prices) Prof. Lasse H. Pedersen 2 CAPM: Introduction ? Equilibrium model that – predicts optimal portfolio choices – predicts the relationship between risk and expected return – underlies much of modern finance theory – underlies most of real-world financial decision making ? Derived using Markowitz’s principles of portfolio theory, with additional simplifying assumptions. ? Sharpe, Lintner and Mossin are researchers credited with its development. ? William Sharpe won the Nobel Prize in 1990. Prof. Lasse H. Pedersen 3 CAPM Assumptions ? Stylized Assumptions: 1. The market is in a competitive equilibrium; 2. Single-period investment horizon; 3. All assets are tradable; 4. No frictions; 5. Investors are rational mean-variance optimizers with 6. homogeneous expectations ? Some assumptions can be relaxed, and CAPM still holds. ? An important approximation of reality in any case. ? If many assumptions are relaxed, generalized versions of CAPM applies. (Topic of ongoing research.) Prof. Lasse H. Pedersen 4 1: The market is in a competitive equilibrium ? Equilibrium: – Supply = Demand –