Financial Theory: Lecture 22 Transcript
November 17, 2009
Professor John Geanakoplos:
Okay, but now I want to move to the next topic, which is the topic called the
Capital Asset Pricing Model, and it's in some points the high point of the class. It used to be the high point of
finance. The theory hasn't worked out as well as people thought in recent times, but it's quite a great
achievement and a lot of it was done here at Yale, so I want to explain it to you.
So you see we have a problem so far. If everybody's trying to hedge that means everybody's trying to get a
completely riskless payoff. It's impossible because, I mean, there's real risk in the economy. And what do we
mean by real risk? Well, something in one state is just going to be bad for the whole economy compared to
Maybe we'll run out of oil or something like that. It's impossible that everybody can consume the same thing
in every state, so it's impossible that everybody can perfectly hedge, but everybody wants to perfectly hedge.
So what has to happen? What gives? How does the theory have to change?
Well, the theory's going to change in a simple way, which Shakespeare himself already knew and already told
us about in
The Merchant of Venice
What's going to happen is everybody is going to try and hedge as much as they can by diversifying, but
because there's some real risk in the economy, in some states things will be in the aggregate worse than they
will be in other states. So what's the consequence of that?
The consequence of that is if you're going to buy an asset that pays something that's riskless you're going to
pay the discounted expected return of the asset, but if you're going to buy an asset that's risky you're going to
need a higher rate of return so the price will be less than the expected discounted payoff.
So Shakespeare, remember, said exactly that. When the play begins with Antonio looking melancholy his
interlocutor says, Salerio or somebody asks him whether he's worried about his businesses. He says, "No, I've
got a different ship--every ship's on a different ocean so I'm diversified. I'm not that worried." So Shakespeare
knows about diversification and that's what everybody should do, but then when it comes time to pick the
caskets to get to marry the beautiful Portia, who by the way is not just beautiful but she's rich so they're
looking for a prize, but they sign a contract that whoever picks the wrong casket not only doesn't get Portia,
he can never marry anyone in the future. So what's the purpose of that contract? It's to make it a very risky
gamble. And so why did Shakespeare want to make it a risky gamble, so he could explain he understands risk
So you remember the conversation where everybody says, "Well, I'm not going to pick this unless, you know,
it's only because she's so rich and so beautiful that I'm willing to do this. The return is so high that it's worth
the risk to me." So Shakespeare already understood that things that are risky are going to have to be priced