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Lecture 3.1: The Capital Asset Pricing Model

(CAPM): Motivation
Investment Analysis
Fall, 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 15, 2012
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Readings and Assignments
Chapter 13 of the course textbook (EGBG) covers related
material.
Homework 3 is available on the Courses Wall.
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Equilibrium Models: Motivation
Mean-variance analysis enables an individual or institution to select an
optimum portfolio, given estimates of expected returns and variances of
securities, and covariances between them.
The prices and returns at which nancial markets will clear (equilibrium)
are determined by aggregating the behavior of all investors.
the construction of equilibrium models allows us to determine:
1
The relevant measure of risk for any asset
2
The relationship between expected return and risk for any asset
when markets are in equilibrium
3
Characteristics of optimum portfolios
Today Motivation
Equilibrium Models: Motivation
Mean-variance analysis enables an individual or institution to select an
optimum portfolio, given estimates of expected returns and variances of
securities, and covariances between them.
The prices and returns at which nancial markets will clear (equilibrium)
are determined by aggregating the behavior of all investors.
the construction of equilibrium models allows us to determine:
1
The relevant measure of risk for any asset
2
The relationship between expected return and risk for any asset
when markets are in equilibrium
3
Characteristics of optimum portfolios
Today Motivation
Equilibrium Models: Motivation
Mean-variance analysis enables an individual or institution to select an
optimum portfolio, given estimates of expected returns and variances of
securities, and covariances between them.
The prices and returns at which nancial markets will clear (equilibrium)
are determined by aggregating the behavior of all investors.
the construction of equilibrium models allows us to determine:
1
The relevant measure of risk for any asset
2
The relationship between expected return and risk for any asset
when markets are in equilibrium
3
Characteristics of optimum portfolios
Today Motivation
Equilibrium Models: Motivation
Mean-variance analysis enables an individual or institution to select an
optimum portfolio, given estimates of expected returns and variances of
securities, and covariances between them.
The prices and returns at which nancial markets will clear (equilibrium)
are determined by aggregating the behavior of all investors.
the construction of equilibrium models allows us to determine:
1
The relevant measure of risk for any asset
2
The relationship between expected return and risk for any asset
when markets are in equilibrium
3
Characteristics of optimum portfolios
Today Motivation
Equilibrium Models: Motivation
Mean-variance analysis enables an individual or institution to select an
optimum portfolio, given estimates of expected returns and variances of
securities, and covariances between them.
The prices and returns at which nancial markets will clear (equilibrium)
are determined by aggregating the behavior of all investors.
the construction of equilibrium models allows us to determine:
1
The relevant measure of risk for any asset
2
The relationship between expected return and risk for any asset
when markets are in equilibrium
3
Characteristics of optimum portfolios
Today Motivation
Equilibrium Models: Motivation
Mean-variance analysis enables an individual or institution to select an
optimum portfolio, given estimates of expected returns and variances of
securities, and covariances between them.
The prices and returns at which nancial markets will clear (equilibrium)
are determined by aggregating the behavior of all investors.
the construction of equilibrium models allows us to determine:
1
The relevant measure of risk for any asset
2
The relationship between expected return and risk for any asset
when markets are in equilibrium
3
Characteristics of optimum portfolios
Today Motivation
The Capital Asset Pricing Model (CAPM)
The rst and simplest equilibrium model developed was the standard
or one-factor Capital Asset Pricing Model (Sharpe (1964), Lintner
(1965), Mossin (1966))
Serves two vital functions:
1
Provides a benchmark rate of return for evaluating possible
investments.
2
Make an educated guess as to the expected return on assets that
have not yet been traded in the market (e.g., price of an IPO of
stock)
Today Motivation
The Capital Asset Pricing Model (CAPM)
The rst and simplest equilibrium model developed was the standard
or one-factor Capital Asset Pricing Model (Sharpe (1964), Lintner
(1965), Mossin (1966))
Serves two vital functions:
1
Provides a benchmark rate of return for evaluating possible
investments.
2
Make an educated guess as to the expected return on assets that
have not yet been traded in the market (e.g., price of an IPO of
stock)
Today Motivation
The Capital Asset Pricing Model (CAPM)
The rst and simplest equilibrium model developed was the standard
or one-factor Capital Asset Pricing Model (Sharpe (1964), Lintner
(1965), Mossin (1966))
Serves two vital functions:
1
Provides a benchmark rate of return for evaluating possible
investments.
2
Make an educated guess as to the expected return on assets that
have not yet been traded in the market (e.g., price of an IPO of
stock)
Today Motivation
The CAPM: Agenda
Assumptions (Lecture 3.2)
Derivation (Lecture 3.2)
Implications for Investment Practice and Performance Evaluation
(Lecture 3.3)
Empirical Performance: How Well Does the CAPM Work in Practice?
(Lecture 3.4)