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CH 06
CH 06
CH 06
(6.1)
Pt E Dt 1 I t E Pt 1 I t 1 r
• If the asset price were to deviate from this, then there would
be opportunities for traders to make profits.
Dt 1 (1 g ) Dt
Dt 2 (1 g ) Dt 1 (1 g ) Dt 2
Dt 3 (1 g ) Dt 2 (1 g ) Dt 3
Dt 1 g Dt 1 g Dt 1 g
2 3
(6.10) Pt ..........
1 r 1 r 2
1 r 3
(6.11) 1 g 1 g 2 1 g 3
P Dt .......
1 r 1 r 1 r
• Next, we need to make an assumption that the
growth rate is less than the interest rate:
1 g
1
1 r
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Gordon growth model
• In (6.11), the terms in the square brackets can be simplified by using the
rule for finding a sum to infinity: 1 g
1 r
Pt Dt
1 g
1 1 r
way:
(6.17) ERi Rrf i ERm Rrf
• For each asset, the excess return over the risk-free rate is
related to the excess return of the market portfolio over the
risk-free rate of return by the coefficient, βi.
• This is the central element of the CAPM model.
• Each Beta gives an indication as to how an asset can be
used to diversify risks.
• If βi<1, then the returns of asset i move less than the market
portfolio. This offers individuals the ability to diversify
income shocks. For example, if 0< βi<1, then following a
fall in the overall stock market, the fall in the returns of
asset i would be correspondingly less.
(6.18b) E Rp Rrf w * E Rr Rrf
• The riskiness of the portfolio, though,
depends on the relative variances of the two
assets.
• The variance of the portfolio is then:
(6.19) 2 2,
p w * r 1 w * rf
2 2 2
2 w2 * 2 p r
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Tobin model of portfolio selection
• This can be rearranged so that the weight w
can be expressed as the ratio of the standard
deviation of the portfolio to the risky asset:
(6.20) p w2
* r w * r ,
2
p
Substituting this ratio into (6.18) w gives us an
r
equation which describes the risk return
trade-off that the investor faces:
(6.21) E R R * ER R
p rf
p
r rf
r
(6.22) U U R,
• This utility function generates a suite of indifferences
curves, which shows the combinations of risks and return
that gives the investor a given level of utility. These
indifference curves are upward sloping because investors
see returns as a good thing, but risk as a bad thing.
Therefore, as the investor is forced to hold a portfolio with
greater risk, they require higher returns in order to keep
their utility at the same level.
(6.23) Pt Pt 1 t
where εt is a stochastic term which represents news
innovations.
• This reflects the fact that economies grow over time and
this growth is reflected in the fundamental values of assets.
(6.25) Pt t
(6.26)
Pt Pt 1 t
• For the EMH to describe asset prices, it is required that β=0,
i.e., no past changes in prices are significant determinants of
current price changes.
• The second relates to the idea that it takes time for new
technology to be represented in asset prices. Information
technology began to emerge in the 1960s; the sharp rise in
asset prices during the 1990s simply reflects the New
Economy firms replacing the Old Economy firms in the
stock market listings.