ECON 136: Financial Economics
Section 11 (Nov 13th)
Xing Huang
1
Economics Department, UC Berkeley
1
Review
1.1
The Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) assumes
(1) all investors are price takers
(2) all investors care about returns measured over one period
(3) all assets are traded
(4) investors can borrow or lend at a given riskfree rate
(5) investors pay no taxes or transactions costs
(6) all investors are meanvariance optimizers
(7) all investors perceive the same means, variances, and covariances for returns.
If the CAPM assumptions are true, then the market portfolio is the tangency portfolio.
Note: the market portfolio is the valueweighted portfolio of all traded assets in the economy.
Why? Because all investors are meanvariance optimizers, we know by the mutual fund the
orem that they hold various combinations of the riskfree asset and the tangency portfolio.
Because the market supply of risky assets must equal the market demand for assets, the mar
ket portfolio must be the tangency portfolio that investors are demanding. In other words, this
result says that all investors hold combinations of the riskfree asset and the valueweighted
portfolio of all traded assets.
return
R
i
,
E
[
R
i
]
±
R
f
=
i
(
E
[
R
m
]
±
R
f
)
where
R
m
is the return on the market portfolio and
i
=
Cov
(
R
i
; R
m
)
=V ar
(
R
m
)
.
Why? The formal argument is long, but it is based on the idea that the market return is
meanvariance e¢ cient, so you cannot increase the expected return of the market portfolio by
making an adjustment into asset
i
without increasing your portfolio variance. Note that the
expected returnbeta representation of CAPM has the nice interpretation: E[excess return] =
quantity of risk*price of risk.
1
These notes are enormously bene±ted from previous GSIs: Keith Jacks Gamble, Dan Hartley and Congyan Tan.
Thank you all very much !!
1
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Testing the CAPM
In practice the CAPM can be tested by estimating the timeseries regression:
R
i;t
R
f;t
=
a
i
+
i
(
R
m;t
R
f;t
) +
e
i;t
Here
a
i
= the estimated expected excess return on asset
i
that is not due to its risk, which
is captured by
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 Fall '08
 SZEIDL
 Economics, Capital Asset Pricing Model

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