1. Economics 434: The Theory of Financial Markets
Professor Burton
Fall 2016
October 13, 2016

2. Chapters 1-9 – available on Collab
Readings
Chapters 1-9 – available on Collab
So far, all 9 chapters plus “Random Walk Down Wall Street”
October 13, 2016

3. The Capital Asset Pricing Model
Markowitz – mean, variance analysis
Tobin – the role of the risk free rate
Sharpe (and others) – beta and the market basket
September 15, 17, 2015

4. Main Conclusion of Markowitz Theory
Mean
Boundary of “feasible” portfolios
“Efficient” Portfolios σ σ
September 15, 17, 2015

5. Tobin’s Result Mean Use of Leverage E Risk Free Asset
Standard Deviation

6. The Capital Asset Pricing Model
Markowitz – mean, variance analysis
Tobin – the role of the risk free rate
Sharpe (and others) – beta and the market basket

7. 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)

8. M – the “efficient” basket The pricing rule based upon “beta”
CAPM – two conclusions
M – the “efficient” basket
The pricing rule based upon “beta”
Bill Sharpe

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

10. i = Rf + i [M – Rf] i M Security Market Line Mean Rf
Beta 1

11. M contains everything of value, weighted by market value
Things to think about
Beta is not volatility
Beta can be negative
M contains everything of value, weighted by market value
Excess return ≡ E[R] – Rf
“Beta equation” relates excess returns
October 13, 2016

12. How do you test this theory
You need M
Or some proxy for M
Usually S&P500 or Russell 3000 used as a proxy for M in beta calculations
October 13, 2016

13. Richard Roll’s Critique (1977)
Using a proxy for M won’t work
CAPM could be false
But the proxy might make it look true
CAPM might be true
But tests using the proxy might make it look false
Conclusion: theory is not testable unless you have the true M
October 13, 2016

14. October 13, 2016