A. Market Equilibrium: CAPM and APT i troduction pice forrsk andthe appropriate measare of risk fora single asset. One economic model fo solve his problem, called the capital asst pricing model (CAPM), was developed elmest simaltaneousty by Sharpe (1963, 1964] and Treynor {1961}, and then further developed by Mossin L966}, Lintner 11963, 1969), and Back [1972] shows thatthe equilibrium rte of return on all risky asses are e faction oftheir covariance withthe market portfolio. second important euilibriie pricing model, called the arbitrage pricing theory (APT), was developed by Ross [1976], Is similar to the CAPM in thatitis also an equilibrium asset pricing model. The rtur on any risky assetis seen to bea linear combination of various common factors that affetaset returns kis more general than the CAPM becanse it llows numerous factors explain the equilibriom enum on a risky asset, Howerves, its in the samme spirits the CAPM. In fac, the CAPM can be shown to be & Special cist of the APT. ‘This chapter first develops the CAPM and its extensions, and then summarizes the empirical evidence relating to its validity. Thereafter, the APT willbe developed and the empirical evidence foci wil be deserved, We begin ith ais of he somos that were edo ete T ritiesatapnenmsern irc to determine the market » CAPM. “Fie CAPM isdeelpen#iypecal word whee the following asumpions ae mide about investors and the opportunity set L Invests ar sk avn wo miei iy of ei wet. a os ae sii ta Sy a i 9 : 1a148 ‘Chapter 6: Maret Equlivum: CAPM aed APT 43, There exists a risk-free asset such that investors may borrow or Tend unlimited amounts ata risk-free rate 4. Tae quantities of assets ae fixed. Also, all assets are marketable and perfectly divisible. 5. Asset markets are ficionless, and information is costless and sioultaneously avaiable to all investors. 6. There ate no marke imperfections such as taxes, regutations of restrictions on shor seling, Many of these assumptions have been discussed eacie. However, i is worthwhile to discuss some oftheir implications. For example if markets re frictionless, the borrowing rate equals the lensing rate, and we are able to develop linear eficiet se called the capital market fine (Fig 5.17 and Bq, 5.34), Hall assetsare divisible and marketable, we exclude the possiblity of human capital ‘8 we usually think of i. In other words, slavery i allowed in the model. We are all able to sell {not rent or wages) various portions of ur human capital (2, typing ability or reading ability} to cer investors at market prices, Ancthe importantassumption sthat investors have homogeneous belifs They all make decisions based on an identical opportunity set. In other words, no one can be fooled because everyone has the same infoation atthe sane time. Also, since all investors maximize the expected silty oftheir end-of-period wealth, the model is implicitly a one-period model Aithough not all hese assumptions conform to telity, they se simplifications that permit the «development of the CAPM, which is extremely useful for financial decision making because it quantifies and prices risk, Most ofthe restrictive assumptions will be relaxed later on, g B. «Zhe Efficiency of the Market Portfolio Proof of the CAPM requires that in equilibrium the market portfolio must be an efficient portfolio, {t must ie onthe upper half of the minimum variance opportunity set graphed in Fig. 6.1. One ‘way fo establish hs emicteney ts to argue tar ecause Imvestors nave homogeneous expectalons, they will ll perceive the same minimum variance opportunity set! Even without a risk-free aset, they wil all selec efficent porttios regards of their individual risk tolerances, As shown in Fig. 61, individual I chooses efficient portfolio B, whereas individual I, whois less risk averse, chooses efficient portfolio C. Given that all individuals hold positive proportions of their wealth inefficient portfolis, then che market porfotio must be efficient beeawse (1) the markets simply te sum of al individual holdings and (2 all individna holdings are eliient. ‘Thus. in theory, when all individuals have homogeneous expectations, the market portfolio must be efficient. Without homogeneous expectations, the market portfolio is nt necesserly efficent, and the equilbium mode of capita markets that is derived inthe next section doesnot necessatily hold, Thusthe efficiency ofthe market portfolio andthe capital asset pricing mae are inseparable, joint hypotheses, Iris not possible to test the validity of one without the othet. We stall retum to this important point when we discuss Roll’ critique later in the chapter. "orang pra of heen a be make prin Fara 1976, Che,©. Detivation ofthe CAPM 149 Figure 62 All investors select efficient portfolios off) Desvaion of the CAPM Figure 6.2 shows the expected return and standard deviation ofthe market portfolio, . the risk- free asset, Rj, aod a risky asset. . The straight line connecting the risk-free asset and the market portoti is the capitat marke fine (or example, see Fig. 5.17, in Chapter 5), We know tha if a market cyulibiu isto exis, the prices of al assets mast adjust unl all ae hel by investors. ‘There can be no excess demand, Is other words, prices must be established so tht the supp of all assets equals the demand for holding them. Consequently, in equilibzium the market portfolio ‘ill consist of all marketable assets held in proportion to their value weights. The equilibrium proportion of each ease in the market portfotio must be rate value ofthe iva] aset «a aauket value of all assets. eo {A portfolio consisting of a% invested in risky asset F and (1 — a) in the marke potfotio will have the following mean and standard deviation adja) 4-0, 62) = » 1 li =[ato? + (Loe? 4 talk 2g] 63) where co} = the variance of shy asetf, = te vance oft mare po, sin = the coves basen eit andthe rl pono ‘We shall see sory thatthe market portfolio already contains asset held acconding to its ‘market value weight In fctthe definition ofthe market portfolios that itconsisis of all assets held according to their market value weighs. The opportunity set provided by various combinations ‘of the risky asset and the market portfolio is the line Jl” in Fig. 6.2, The change in the rsean150 Figure 6.2 The oppor- unity set provided by combinations of risky asset 7 and the macket pontoli, 8f ‘Chapter 6: Macket Equilibrium: CAPM and APT snd standasl deviation with respect to the percentage of the portfolio, a invested in asset Tis "Misspeication of Capital Asst Pricing: Bmpwical Anomalies Based on EaingsVieds and Market Values" Jeural of Financial Econo, Mach 18, 19-46. Roll" Cig ofthe Asset cing Theoy’s Tests” Journal of Fiancil Eroncmies, Mach 197, 129-176. "A Possible Explanation of the Sal Finn fest” Journal of Finance, Sepember 1981, 879-888, "A Noe on he Geomety of Shanken’s CSR Toquted Tet for Mean Variance iene.” Journal of Fincciad Eeonomics, Septet |985,349-397. Roll. R and S. 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