Economics 106V
Investments
: Lecture Note5
Daisuke Miyakawa
UCLA Department of Economics
June 27, 2008
5th lecture covers the following items: (1) The basic ideas of Capital Asset Pricing Model (CAPM), (2)
its relationship with the index model, (3) One method to derive CAPM, (4) relationship with the optimal
portfolio problem, (5) the Security Market Line (SML), and (6) another application of CAPM and the
assessment for CAPM. After discussing those items, we solve some exercise problems.
1 The Basic Ideas of CAPM
1.1 Over View
CAPM is an economic model for an asset pricing. Same as any other economic models, it is based on some
assumptions and provides some equilibrium object (e.g., an asset price). While the model is constructed as
a concrete economics model, the basic idea is extremely simple, that is "there is no arbitrage opportunity in
an e¢ cient market".
are trying to maximize their utility based on our familiar meanvariance criteria. So, basically, nothing is
di/erent from the previous lectures. The investors will construct an optimal portfolio somehow and they will
get the price of the securities.
how those assumptions are realistic (or note):
1.2 Assumption(i): Price Taking Investors
CAPM assumes that the market is composed of many small investors. Hence they are pricetakers (i.e.,
perfect competition is assumed). You should be familiar with this assumption since this is a standard
environment for a basic microeconomics model.
In reality, this assumption was fairly realistic until recent years when institutional investors increasingly
began to in±uence the market with their large transactions, especially those transactions via program trading.
The program trading is one automated transaction which processes the buy and sell order based on the
preprogramed criteria. Thanks to its highly automated nature, it became possible to transact a huge size
of deal. Since the 1987 market crash, circuit breakers on program trading have been enacted and market
volatility has decreased somewhat.
1
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document1.3 Assumption(ii): Common Holding Period
CAPM assumes that all investors have the same holding period. This makes it possible to abstract from the
dynamic trading problem. In short, we can ignore the timing of reinvestment thanks to this assumption.
Obviously, di/erent investors have di/erent goals, and thus have di/erent holding periods. Hence, it is
somewhat unrealistic assumption.
1.4 Assumption(iii): Limitation on the Traded Securities & No Financial Con
straints
CAPM assumes that investments are limited to those that are publicly traded. In addition, it is assumed
This is the end of the preview.
Sign up
to
access the rest of the document.
 Summer '08
 Miyakawa
 Economics, Capital Asset Pricing Model, Market Portfolio

Click to edit the document details