fin8 - Assets Pricing Econ 333 Spring 08 1 Assets pricing...

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Econ 333 Spring 08 1 Assets Pricing
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Econ 333 Spring 08 2 Assets pricing Our goals: Understand what the market portfolio is, what assumptions are needed for the market portfolio to be the tangency portfolio, i.e. for the Capital Asset pricing Model (CAPM) to hold. Understand the fundamental theory behind asset pricing models.
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Econ 333 Spring 08 3 The Capital Asset Pricing Model- CAPM Implementing the risk-expected return relation requires observation of the tangency portfolio. However, it is impossible to derive the tangency portfolio simply from observed historical returns on large numbers of assets. First, such an exercise would be extremely complex and inaccurate, requiring thousands of covariance estimates. Moreover, using historical average returns to determine means, and historical return data to estimate the covariances and variances, would only create a candidate tangency portfolio that would be useless for generating forward-looking mean returns. The required rates of return derived from a risk-return relation based on betas with respect to such a tangency portfolio would simply be the average of the historical rates of return used to find the tangency portfolio. Other procedures for identifying the true tangency portfolio are needed. It is necessary to develop a theory that identifies the tangency portfolio from sound theoretical assumptions in order to put some economic substance into the risk-expected return relation described by We shall first introduce one such theory, the CAPM, a model of the relation of risk to expected return. We will then turn to a more general theory of asset pricing, a special case of which is the CAPM, but also the C-CAPM (consumption-CAPM). ) ( f T f i r R r r
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Econ 333 Spring 08 4 The Capital Asset Pricing Model- CAPM The two assumptions of mean-variance analysis: Investors care only about the mean and variance of their portfolio’s returns Markets are frictionless. To develop the CAPM, one additional assumption is needed: Investors have homogenous beliefs , which means that all investors reach the same conclusions about the means and standard deviations of all feasible portfolios. This assumption implies that investors will not be trying to outsmart one another and “beat the market” by actively managing their portfolios. On the other hand, this assumption does not imply that investors can merely throw darts to pick their portfolios: A scientific examination of means, variances and covariances may still be of use, but every person will arrive at the same conclusions about the mean and standard deviation of each portfolio’s return after his/her own scientific examination.
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Econ 333 Spring 08 5 The Capital Asset Pricing Model- CAPM Market portfolio
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fin8 - Assets Pricing Econ 333 Spring 08 1 Assets pricing...

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