Note-5 - CAPM

Note-5 - CAPM - Economics 106V Investments Lecture Note-5...

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Economics 106V Investments : Lecture Note-5 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 mean-variance 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 price-takers (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
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1.3 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
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Note-5 - CAPM - Economics 106V Investments Lecture Note-5...

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