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RECAP: Preference

Ingredients

2) 5 Axioms for Expected Utility

Expected Return E(Rp)

Theorem

3) Prefer more to less (Greedy)

4) Risk aversion

5) Assets jointly normally

distributed

Increasing Utility

Standard Deviation

σ(R )

RECAP: Min-Variance opp. set

E(Rp) - Portfolios along the efficient

set/frontier are referred to as

“mean-variance” efficient

Efficient

frontier

σ(Rp

)

RECAP: Capital Market Line

(a.k.a Linear efficient set)

E(Rp) CML

M

E(RM)

Ingredients

2) Homogenous Belief

3) Unlimited Lending/borrowing

Rf

σ(Rp

σM

)

RECAP: 2-fund separation

Everyone’s U-maximizing portfolio consists of a combination of 2

assets only: Risk-free asset and the market portfolio. This is true

irrespective of the difference of their risk-preferences

CML

E(Rp)

B

E(RM)

(M) Market Portfolio

CML Equation:

A E(Rp) = Rf + [(E(RM)- Rf)/σM]σ(Rp)

Rf

σM

σ(Rp

RECAP: CAPM & SML

E(return) = Risk-free rate of return + Risk premium specific to asset i

= Rf + (Market price of risk)x(quantity of risk of asset i)

E(Ri) E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)]

E(Ri) = Rf + [E(RM)-Rf] x βi

SML

E(RM)

slope = [E(RM) - Rf] = Eqm. Price of risk

Rf

βM = 1 βi = COV(Ri, RM)/Var(RM)

Empirical Studies of CAPM

• Is CAPM useful?

– Given many unrealistic assumptions, how good does the model

fit into the reality?

[1] What exactly are the predictions of the CAPM?

[2] Are they testable?

[3] What is a regression?

[4] How to test hypothesis? What is t-test?

[1] What are the predictions ?

[a] CAPM says: more risk, more rewards

[b] HOWEVER, “reward-able” risk ≠ asset

total risk, but = systematic risk (beta)

[c] We ONLY need Beta to predict returns

[d] return LINEARLY depends on Beta

[2] Testable ?

E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)]

E(Ri) = Rf + [E(RM)-Rf] x βi

[a] Risk-free borrowing/lending rate {Rf}

[b] Expected return on the market {E(RM)}

[c] The exposure to market risk

{βi = cov(Ri,RM)/var(RM)}

[2] Testable ?

E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)]

E(Ri) = Rf + [E(RM)-Rf] x βi

[a] short-term T-bill (not entirely risk-free) {Rf}

[b] Proxy of market-portfolio (not the true

market) {E(RM)}

[c] Historical beta

{βi = cov(Ri,RM)/var(RM)}

[2] Testable ?

Problem 1:

What is the market portfolio? We never truly

observe the entire market.

We use stock market index to proxy market,

but:

[i] only 1/3 non-governmental tangible assets

are owned by corporate sector. Among them,

only 1/3 is financed by equity.

[ii] what about intangible assets, like human

capital?

[2] Testable ?

Problem 2:

Without a valid market proxy, do we really

observe the true beta?

[i] suggesting beta is destined to be estimated

with measurement errors.

[ii] how would such measurement errors bias

our estimation?

[2] Testable ?

Problem 3:

Borrowing restriction.

Problem 4:

Expected return measurement.

[i] are historical returns good proxies for future

expected returns? Ex Ante VS Ex Post

[3] Regression

E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)]

E(Ri) = Rf + [E(RM)-Rf] x βi

E(Ri) – Rf = [E(RM)-Rf] x βi

With our compromises, we test :

[Ri – Rf] = [RM-Rf] x βi

Using the following regression equation :

[Rit – Rft] = γ0 + γ1βi + εit

In words,

Excess return of asset i at time t over risk-free rate

is a linear function of beta plus an error (ε).

Cross-sectional Regressions to be performed!!!

[3] Regression

[Rit – Rft] = γ0 + γ1βi + εit

CAPM predicts:

[a] γ0 should NOT be significantly different

from zero.

[b] γ1 = (RMt - Rft)

[c] Over long-period of time γ1 > 0

[d] β should be the only factor that explains

the return

[e] Linearity

[4] Generally agreed results

[Rit – Rft] = γ0 + γ1βi + εit

[a] γ0 > 0

[b] γ1 < (RMt - Rft)

[c] Over long-period of time, we have γ1 > 0

[d] β may not be the ONLY factor that explains the

return

(firm size, p/e ratio, dividend yield, seasonality)

[e] Linearity holds, β2 & unsystematic risk become

insignificant under the presence of β.

[4] Generally agreed results

[Rit – Rft]

CAPM Predicts

Actual

γ1 = (RMt - Rft)

γ0 = 0 βi

Roll’s Critique

Message: We aren’t really testing CAPM.

empirically elusive. It is not theoretically clear which assets (e.g.,

human capital) can legitimately be excluded from the market

portfolio, and data availability substantially limits the assets that

are included. As a result, tests of CAPM are forced to use

compromised proxies for market portfolio, in effect testing whether

the proxies are on the min-variance frontier.”

testable. We do not have the benchmark market to base on. Every

implications are tested jointly with whether the proxy is efficient or

not.

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