Economics 434 Financial Markets Professor Burton University of Virginia Fall 2015 September 24, 2015
Definition of an Asset in Modern Portfolio Theory: As a probability distribution of returns (usually a normal distribution) Instead of three (or any finite number of) states, there are an infinity of states possible with various probabilities of returns assigned -- Returns -- Probability Density Function September 18, 2014
Modern Portfolio Theory Randomness Construction of efficient (best) portfolios Harry Markowitz September 18, 2014
Harry Markowitz’s Conclusion Standard Deviation Mean Maximizes Utility September 18, 2014
James Tobin’s Result Mean Standard Deviation Risk Free Asset Use of Leverage E September 18, 2014
CAPM – two conclusions M – the “efficient” basket The pricing rule based upon “beta” September 18, 2014 Bill Sharpe
Capital Market Line What is M ? RfRf M Mean STDD Answer: contains all “positively” priced assets, weighted by their “market” values. September 18, 2014
Security Market Line i = R f + i [ M – R f ] Rf Beta Mean MM 1 Security Market Line ii September 18, 2014
Richard Roll – UCLA, 1982 Not a testable theory Can’t find market basket Without true market basket, can reach wrong conclusion Is Beta dead? September 18, 2014 Is CAPM Testable?
Fama-French 1982 by Eugene Fama and Kenneth French Research designed to test whether or not CAPM is true – Findings Beta is largely irrelevant Book/Market positively related to future performance Size negatively related to future performance September 18, 2014
Performance Evaluation Absolute Return Doesn’t Tell You Much Need to Know What Risk Was Taken Beta is the normal measure of risk “Risk Adjusted” Performance is now the norm September 18, 2014
Roll’s Criticism Applies Here Data might show superior performance When performance is actually inferior Data might show inferior performance When performance is actually superior September 18, 2014
Two Things Keep Beta Going The Limit Theorem Ease of Computation September 18, 2014
September 24, 2015