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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?
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.