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

2. 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

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

4. 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

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

6. 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

7. 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

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

9. 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

10. 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

11. October 11, 2018