Financial Market Theory Thursday, October 25, 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 25, 2018

CAPM – two conclusions M – the “efficient” basket Bill Sharpe M – the “efficient” basket The pricing rule based upon “beta” October 25, 2018

Capital Market Line M Rf Mean What is M ? Answer: contains all “positively” priced assets, weighted by their “market” values. Rf STDD October 25, 2018

i = Rf + i [M – Rf] i M Security Market Line Mean Rf Beta 1 October 25, 2018

Roll’s Criticism of CAPM To test CAPM, you must know the market basket, M. There is no approximation that can be used. Using an approximation to M, can validate the theory when it is incorrect; invalidate the theory when it is correct. In essence, the theory is not testable, since M cannot be found (the theory is about all assets, not just stocks) There has never been answer to Roll’s critique

Arbitrage Pricing Theory Developed by Steve Ross, 1976 Uses “No-Arbitrage” Assumption Designed to provide “economic” variables to the determination of asset pricing Avoids the “single risky asset portfolio” problem October 25, 2018

The Starting Point of APT 𝑅 𝑖 =𝐸 𝑅 𝑖 + β 𝑖1 𝐹 1 + β 𝑖2 𝐹 2 + … + β 𝑖𝑛 𝐹 𝑛 Ri is the return in a single period for stock i 𝐸 𝑅 𝑖 Is the expected return of stock i 𝐹 𝑖 is the “unanticipated” change in factor i October 25, 2018

After a bit of linear algebra and taking a limit of arbitrage portfolios that increase in size 𝐸 𝑅 𝑖 − 𝑅 𝑓 = β 𝑖1 γ 1 + β 𝑖2 γ 2 + … β 𝑖𝑛 γ 𝑛 What is γ 1 ? γ 𝑖 = E 𝐹𝑅 𝑖 − 𝑅 𝑓 The expected excess return attributable to a beta of one exposure to factor i October 25, 2018

So, What are the Economic Factors According to Richard Roll & Steve Ross Inflation Industrial production Risk premiums (credit spreads) Slope of the term structure of interest rates October 25, 2018

October 25, 2018