1. Financial Market Theory
Thursday, October 25, 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 25, 2018

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

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

6. 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

7. 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

8. The Starting Point of APT
𝑅 𝑖 =𝐸 𝑅 𝑖 β 𝑖1 𝐹 1 + β 𝑖2 𝐹 … + 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

9. 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

10. 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

11. October 25, 2018