lecture12-2k - AEB 6182 Lecture XII Professor Charles Moss...

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AEB 6182 Lecture XII Professor Charles Moss 1 The Capital Asset Pricing Model Lecture XII I. Literature A. Most of today’s materials comes from Eugene F. Fama and Merton H. Miller The Theory of Finance (Hinsdale, Illinois: Dryden Press, 1972) Chapter 7. B. The primary literature is: 1. Lintner, John. “Security Prices, Risk, and Maximal Gain from Diversification.” Journal of Finance 20(Dec. 1965): 587-615. 2. Lintner, John. “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics 47(Feb. 1965): 13-37. 3. Mossin, Jan. “Equilibrium in a Capital Asset Market.” Econometrica 34(Oct. 1966): 768-83. 4. Sharpe, W. F. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” Journal of Finance 19(Sept. 1964): 425-42. II. Setting Up the Market A. Perfect Markets: We assume that all markets are competitive for goods and investments. 1. All goods and investments are infinitely divisible. 2. Information is costless. 3. There are no transaction costs. 4. No individual is large enough to effect the price. B. Firms: All goods are produced by firms. These firms purchase the factors of production in the first period, produce output, and market their goods in the second period. In addition, these firms do not have any capital of their own and must raise this capital by issuing stock. C. Consumers: Consumers begin with an endowment w 1 . The consumer’s choice problem (initially) is twofold. 1. First, the consumer must decide how much to consume in this period, c 1 , and how much to invest, h 1 . This investment will earn a rate of return h 1 (1+R i ) which will be consumed in the second period, c 2 . 2. Second, the consumer must decide how to invest h 1 , that is how to divide it up between a wide array of assets. In general, this implies two decision dimensions. The first is intertemporal (across time). In this decision the consumer has a time preference, the preference between consuming now and consuming later.
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AEB 6182 Lecture XII Professor Charles Moss 2 c 1 c 2 1/(1+r) U(c 1 ,c 2 ) The second is the risk or uncertainty on the investment. Both of these questions can be represented in the utility function. D.
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lecture12-2k - AEB 6182 Lecture XII Professor Charles Moss...

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