15.433INVESTMENTS Classes6:The CAPM and APT
Part1:Theory
Spring2003
Introduction
So far,we took the expected return of risky asset as given.But where does expected return come from?
Using the intuition that investors are risk averse,one explanation is that the risk premium-expected return in excess of the riskfree rate-is a reward for bearing risk.
Does this make sense?
The Capital Asset Pricing Model(CAPM)provides a simple,yet elegant framework for us to think about the question of reward and risk.
”The CAPM”
In market equilibrium,investors are only rewarded for bearing systematic risk-the type of risk that cannot
be diversified away.
They should not be rewarded for bearing idiosyncratic risk,since this uncertainty can be mitigated through appropriate diversification.
Sharpe on CAPM
Bill Sharpe,one of the originators of the CAPM,in an interview with the Dow Jones Asset Manager:
”But the fundamental idea remains that there’s no reason to expect re-ward just for bearing risk.Otherwise,you’d make a lot of money in Las Vegas.If there’s reward for risk,it’s got to be special.There’s got to be some economics behind it or else the world is a very crazy place.I don’t think differently about those basic ideas at all”.wispring是什么意思
-Sharpe(1998)
Assumptions
1.Perfect Markets
•Perfect competition-each investor assumes he has no effect on security prices •No taxes
•No transactions costs
•All assets publicly traded,perfectly divisible
•No short-sale constraints
•Same riskfree rate for borrowing and lending
2.Identical Investors
•Myopic1
•Same holding period
•Normality or Mean-Variance Utility
•Homogeneous expectations
1myopic:adj.Of,pertaining to,or affected with myopia;short-sighted,near-sighted
The  Equilibrium  Market  Portfolio  Recall  that  every  investor  holds  some  combination  of  the  riskless  asset  and  the  tan­gency  portfolio.
µi
m e a n  µ (%) r f C M L
o
o
µΜ σΜ
Market 0
σi
std σ (%) Figure  1: Equilibrium  market  portfolio  and  efficient  frontier.
When  we  aggregate  the  portfolios  of  all  individual  investors, lending  and  borrowing  will  cancel  out, and  the  value  of  the  aggregated  risky  portfolio  will  equate  the  en-tire  wealth  of  the  economy. The  tangent  portfolio  has  become  the  equilibrium  market  portfolio.

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