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Lecture 3.1: The Capital Asset Pricing Model(CAPM): Motivation

Investment AnalysisFall, 2012

Anisha Ghosh

Tepper School of BusinessCarnegie Mellon University

November 15, 2012

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Readings and Assignments

Chapter 13 of the course textbook (EGBG) covers relatedmaterial.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 anoptimum portfolio, given estimates of expected returns and variances ofsecurities, and covariances between them.

The prices and returns at which financial 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 asset2 The relationship between expected return and risk for any asset

when markets are in equilibrium3 Characteristics of optimum portfolios

Today Motivation

Equilibrium Models: Motivation

Mean-variance analysis enables an individual or institution to select anoptimum portfolio, given estimates of expected returns and variances ofsecurities, and covariances between them.

The prices and returns at which financial 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 asset2 The relationship between expected return and risk for any asset

when markets are in equilibrium3 Characteristics of optimum portfolios

Today Motivation

Equilibrium Models: Motivation

Mean-variance analysis enables an individual or institution to select anoptimum portfolio, given estimates of expected returns and variances ofsecurities, and covariances between them.

The prices and returns at which financial 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 asset2 The relationship between expected return and risk for any asset

when markets are in equilibrium3 Characteristics of optimum portfolios

Today Motivation

Equilibrium Models: Motivation

Mean-variance analysis enables an individual or institution to select anoptimum portfolio, given estimates of expected returns and variances ofsecurities, and covariances between them.

The prices and returns at which financial 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 asset2 The relationship between expected return and risk for any asset

when markets are in equilibrium3 Characteristics of optimum portfolios

Today Motivation

Equilibrium Models: Motivation

Mean-variance analysis enables an individual or institution to select anoptimum portfolio, given estimates of expected returns and variances ofsecurities, and covariances between them.

The prices and returns at which financial 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 asset2 The relationship between expected return and risk for any asset

when markets are in equilibrium3 Characteristics of optimum portfolios

Today Motivation

Equilibrium Models: Motivation

Mean-variance analysis enables an individual or institution to select anoptimum portfolio, given estimates of expected returns and variances ofsecurities, and covariances between them.

The prices and returns at which financial 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 asset2 The relationship between expected return and risk for any asset

when markets are in equilibrium3 Characteristics of optimum portfolios

Today Motivation

The Capital Asset Pricing Model (CAPM)

The first and simplest equilibrium model developed was the standardor 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 ofstock)

Today Motivation

The Capital Asset Pricing Model (CAPM)

The first and simplest equilibrium model developed was the standardor 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 ofstock)

Today Motivation

The Capital Asset Pricing Model (CAPM)

The first and simplest equilibrium model developed was the standardor 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 ofstock)

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)