Financial Market Theory Thursday, October 11, 2018 Professor Edwin T Burton

Capital Asset Pricing Model Makes all the same assumptions as Tobin model But Tobin’s model is about “one person” CAPM puts Tobin’s model in equilibrium, by assuming that everyone faces the same portfolio choice problem as in Tobin’s problem Only difference between people in CAPM is that each has their own preferences (utility function) October 11, 2018

CAPM – two conclusions M – the “efficient” basket Bill Sharpe M – the “efficient” basket The pricing rule based upon “beta” October 11, 2018

Capital Market Line M Rf Mean What is M ? Answer: contains all “positively” priced assets, weighted by their “market” values. Rf STDD October 11, 2018

i = Rf + i [M – Rf] i M Security Market Line Mean Rf Beta 1 October 11, 2018

Applications of CAPM (see Chapter 11) Cost of Equity Capital Asset Allocation for Large Pension Funds and Endowments Sharpe Ratio Information Ratio Jensen’s Alpha October 11, 2018

Cost of Equity Capital “Required Equity Return” = Rf + βi { E[RM] – Rf} Seems straight forward, but what happens if your stock doubles? Then the argument is that your beta, going forward, will be much less than it was before No justification whatsoever for this argument, beta should just be beta and independent of recent market moves “Debt Cost of Capital” = interest costs minus the tax shield October 11, 2018

The Sharpe Ratio ≡ 𝑬[ 𝒓 𝑷 ]− 𝑹 𝒇 𝝈 𝑷 October 11, 2018

Information Ratio (& Tracking Error) The Information Ratio ≡ 𝑬[ 𝒓 𝒂 − 𝒓 𝒃 ] 𝒗𝒂𝒓[ 𝒓 𝒂 − 𝒓 𝒃 ] Tracking Error = 𝒗𝒂𝒓[ 𝒓 𝒂 − 𝒓 𝒃 ] b is the benchmark, e.g. S&P500 October 11, 2018

Jensen’s Alpha 𝜶 𝒊 ≡ 𝑹 𝒊 − 𝑹 𝒇 − 𝜷 𝒊 𝑹 𝑴 − 𝑹 𝒇 𝜶 𝒊 ≡ 𝑹 𝒊 − 𝑹 𝒇 − 𝜷 𝒊 𝑹 𝑴 − 𝑹 𝒇 Note: no expected returns in this formula October 11, 2018

October 11, 2018