Eco 525: Financial Economics I
Lecture 05: Mean-Variance Analysis & Capital Asset Pricing Model (CAPM)
Prof. Markus K. Brunnermeier
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-1
Eco 525: Financial Economics I
Overview
Simple CAPM with quadratic utility functions
(derived from state-price beta model)
Mean-variance preferences
Portfolio Theory CAPM (intuition)
CAPM
Projections Pricing Kernel and Expectation Kernel
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-2
Eco 525: Financial Economics I
Recall State-price Beta model
Recall: E[Rh] - Rf = h E[R*- Rf] where h := Cov[R*,Rh] / Var[R*]
very general but what is R* in reality?
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-3
Eco 525: Financial Economics I
Simple CAPM with Quadratic Expected Utility
1. All agents are identical
Expected utility U(x0, x1) = s s u(x0, xs) m= 1u / E[0u] Quadratic u(x0,x1)=v0(x0) - (x1- )2 1u = [-2(x1,1- ),, -2(xS,1- )] E[Rh] Rf = - Cov[m,Rh] / E[m] = -Rf Cov[1u, Rh] / E[0u] = -Rf Cov[-2(x1- ), Rh] / E[0u] = Rf 2Cov[x1,Rh] / E[0u] Also holds for market portfolio E[Rm] Rf = Rf 2Cov[x1,Rm]/E[0u]
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-4
Eco 525: Financial Economics I
Simple CAPM with Quadratic Expected Utility
2. Homogenous agents + Exchange economy x1 = agg. endowment and is perfectly correlated with Rm
E[Rh]=Rf + h {E[Rm]-Rf} Market Security Line
N.B.: R*05 f (a+b1RMMean-Variance fAnalysis and CAPM (where b1<0)! =R )/(a+b1R ) in this case 16:14 Lecture
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-5
Eco 525: Financial Economics I
Overview
Simple CAPM with quadratic utility functions
(derived from state-price beta model)
Mean-variance analysis
Portfolio Theory (Portfolio frontier, efficient frontier, ) CAPM (Intuition)
CAPM
Projections Pricing Kernel and Expectation Kernel
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-6
Eco 525: Financial Economics I
Definition: Mean-Variance Dominance & Efficient Frontier
Asset (portfolio) A mean-variance dominates asset (portfolio) B if A B and A < or if A>Bwhile A B. Efficient frontier: loci of all non-dominated portfolios in the mean-standard deviation space. By definition, no (rational) mean-variance investor would choose to hold a portfolio not located on the efficient frontier.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-7
Eco 525: Financial Economics I
Expected Portfolio Returns & Variance
Expected returns (linear) Variance
h p := E[rp ] = wj j , where each j = P
j j
hj
2 p := V ar[rp ]
= = =
w 0 V w = (w1 w2 )
2 (w1 1 + w2 21
2 1
21
12 2 2
2 w1 12 + w2 2 )
2 2 2 2 w1 1 + w2 2 + 2w1 w2 12 0
w1 w2 w1 w2
since 12 1 2 .
recall that correlation coefficient [-1,1]
Slide 05-8
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Eco 525: Financial Economics I
Illustration of 2 Asset Case
For certain weights: w1 and (1-w1) p = w1 E[r1]+ (1-w1) E[r2] 2p = w12 12 + (1-w1)2 22 + 2 w1(1-w1)1 2 1,2 (Specify 2p and one gets weights and ps) Special cases [w1 to obtain certain R]
1,2 = 1 w1 = (+/-p 2) / (1 2) 1,2 = -1 w1 = (+/- p + 2) / (1 + 2)
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-9
Eco 525: Financial Economics I
For 1,2 = 1: p
p
= =
|w1 1 + (1 w1 )2 | w1 1 + (1 w1 )2
Hence, w1 =
p 2 1 2
E[r2]
p
E[r1]
p 2
Lower part with is irrelevant
The Efficient Frontier: Two Perfectly Correlated Risky Assets
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-10
Eco 525: Financial Economics I
For 1,2 = -1:p
p
= =
|w1 1 (1 w1 )2 |
Hence, w1 =
w1 1 + (1 w1 )2
p +2 1 +2
E[r2]
2 1 +2 1
slope:
+ 11 2 2 +
E[r1]
2 1 1 +2 p
1 slope: 2 2 p 1 +
Efficient Frontier: Two Perfectly Negative Correlated Risky Assets
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-11
Eco 525: Financial Economics I
For -1 < 1,2 < 1:
E[r2]
E[r1]
Efficient Frontier: Two Imperfectly Correlated Risky Assets
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-12
Eco 525: Financial Economics I
For 1 = 0
E[r2]
p
E[r1]
The Efficient Frontier: One Risky and One Risk Free Asset
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-13
Eco 525: Financial Economics I
Efficient Frontier with
n risky assets and one risk-free asset
The Efficient Frontier: One Risk Free and n Risky Assets
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-14
Eco 525: Financial Economics I
Mean-Variance Preferences
U(p, p) with
U p
> 0,
U 2 p
<0
quadratic utility function (with portfolio return R) U(R) = a + b R + c R2 vNM: E[U(R)] = a + b E[R] + c E[R2] = a + b p + c p2 + c p2 = g(p, p) asset returns normally distributed R=j wj rj normal
if U(.) is CARA certainty equivalent = p - A/22p (Use moment generating function)
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-15
Eco 525: Financial Economics I
Optimal Portfolio: Two Fund Separation
Price of Risk = = highest Sharpe ratio
Optimal Portfolios of Two Investors with Different Risk Aversion
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-16
Eco 525: Financial Economics I
Equilibrium leads to CAPM
Portfolio theory: only analysis of demand
price/returns are taken as given composition of risky portfolio is same for all investors
Equilibrium Demand = Supply (market portfolio) CAPM allows to derive
equilibrium prices/ returns. risk-premium
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-17
Eco 525: Financial Economics I
The CAPM with a risk-free bond The market portfolio is efficient since it is on the efficient frontier. All individual optimal portfolios are located on the half-line originating at point (0,rf). E[ R ] R The slope of Capital Market Line (CML): .
M f M
E[ R p ] = R f +
E[ RM ] R f
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-18
Eco 525: Financial Economics I
The Capital Market Line
CML
rM rf
j
M
16:14 Lecture 05 Mean-Variance Analysis and CAPM
p
Slide 05-19
Eco 525: Financial Economics I
Proof of the CAPM relationship [old traditional derivation]
Refer to previous figure. Consider a portfolio with a fraction 1 - of wealth invested in an arbitrary security j and a fraction in the market portfolio
p = M + (1 ) j
2 2 p = 2 M + (1 ) 2 2 + 2 (1 ) jM j
As varies we trace a locus which
- passes through M (- and through j) - cannot cross the CML (why?) - hence must be tangent to the CML at M Tangency = dp = slope of the
locus at M = r dp =1 = slope of CML = M M f
Mean-Variance Analysis and CAPM Slide 05-20
16:14 Lecture 05
Eco 525: Financial Economics I
at =1 p = M
slope of dp = locus dp
M rf (M j )M |=1 = = 2 M jM M
jM 2 M
slope of =tangent!
E[rj ] = j = rf +
16:14 Lecture 05
(M rf )
Slide 05-21
Do you see the connection to earlier state-price beta model? R* = RM
Mean-Variance Analysis and CAPM
Eco 525: Financial Economics I
The Security Market Line
E(r) SML E(ri)
E(rM)
rf slope SML = (E(ri)-rf) / i
M= 1
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-22
Eco 525: Financial Economics I
Overview
Simple CAPM with quadratic utility functions (derived from state-price beta model) Mean-variance preferences
Portfolio Theory CAPM (Intuition)
CAPM (modern derivation)
Projections Pricing Kernel and Expectation Kernel
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-23
Eco 525: Financial Economics I
Projections
States s=1,,S with s >0 Probability inner product -norm (measure of length)
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-24
Eco 525: Financial Economics I
y x
shrink axes
y x
x and y are -orthogonal iff [x,y] = 0, I.e. E[xy]=0
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-25
Eco 525: Financial Economics I
Projections
Z space of all linear combinations of vectors z1, ,zn
Given a vector y RS solve
[smallest distance between vector y and Z space]
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-26
Eco 525: Financial Economics I
Projections
y
yZ E[ zj]=0 for each j=1,,n (from FOC) z yZ is the (orthogonal) projection on Z y = yZ + , yZ Z, z Analysis and CAPM 16:14 Lecture 05 Mean-Variance
Slide 05-27
Eco 525: Financial Economics I
Expected Value and Co-Variance
squeeze axis by
(1,1)
[x,y]=E[xy]=Cov[x,y] + E[x]E[y] [x,x]=E[x2]=Var[x]+E[x]2 ||x||= E[x2]
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-28
Eco 525: Financial Economics I
Expected Value and Co-Variance
E[x] = [x, 1]=
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-29
Eco 525: Financial Economics I
Overview
Simple CAPM with quadratic utility functions
(derived from state-price beta model)
Mean-variance preferences
Portfolio Theory CAPM (Intuition)
CAPM (modern derivation)
Projections Pricing Kernel and Expectation Kernel
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-30
Eco 525: Financial Economics I
New (LeRoy & Werner) Notation
Main changes (new versus old)
gross return: SDF: pricing kernel: Asset span: income/endowment: r=R =m kq = m* M = <X> wt = et
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-31
Eco 525: Financial Economics I
Pricing Kernel kq
M space of feasible payoffs. If no arbitrage and >>0 there exists SDF RS, >>0, such that q(z)=E( z). M SDF need not be in asset span. A pricing kernel is a kq M such that for each z M, q(z)=E(kq z).
(kq = m* in our old notation.)
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-32
Eco 525: Financial Economics I
Pricing Kernel - Examples
Example 1:
S=3,s=1/3 for s=1,2,3, x1=(1,0,0), x2=(0,1,1), p=(1/3,2/3). Then k=(1,1,1) is the unique pricing kernel.
Example 2:
S=3,s=1/3 for s=1,2,3, x1=(1,0,0), x2=(0,1,0), p=(1/3,2/3). Then k=(1,2,0) is the unique pricing kernel.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-33
Eco 525: Financial Economics I
Pricing Kernel Uniqueness
If a state price density exists, there exists a unique pricing kernel.
If dim(M) = m (markets are complete), there are exactly m equations and m unknowns If dim(M) m, (markets may be incomplete) For any state price density (=SDF) and any z M E[(-kq)z]=0 =(-kq)+kq kq is the projection'' of on M.
Complete markets , kq= (SDF=state price density)
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-34
Eco 525: Financial Economics I
Expectations Kernel ke
An expectations kernel is a vector ke M
Such that E(z)=E(ke z) for each z M.
Example If >>0, there exists a unique expectations kernel. Let e=(1,, 1) then for any z M E[(e-ke)z]=0 ke is the projection of e on M ke = e if bond can be replicated (e.g. if markets are complete)
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-35
S=3, s=1/3, for s=1,2,3, x1=(1,0,0), x2=(0,1,0). Then the unique ke=(1,1,0).
Eco 525: Financial Economics I
Mean Variance Frontier
Definition 1: z M is in the mean variance frontier if there exists no z M such that E[z]= E[z], q(z')= q(z) and var[z] < var[z]. Definition 2: Let E the space generated by kq and ke. Decompose z=zE+, with zE E and E. Hence, E[]= E[ ke]=0, q()= E[ kq]=0 Cov[,zE]=E[ zE]=0, since E. var[z] = var[zE]+var[] (price of is zero, but positive variance) If z in mean variance frontier z E. Every z E is in mean variance frontier.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-36
Eco 525: Financial Economics I
Frontier Returns
Frontier returns are the returns of frontier payoffs with non-zero prices.
graphically: payoffs with price of p=1.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-37
Eco 525: Financial Economics I
M = RS = R3
Mean-Variance Payoff Frontier
kq Mean-Variance Return Frontier p=1-line = return-line (orthogonal to kq)
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-38
Eco 525: Financial Economics I
Mean-Variance (Payoff) Frontier
(1,1,1)
standard deviation expected return
kq
NB: graphical illustrated of expected returns and standard deviation changes if bond is not in payoff span.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-39
Eco 525: Financial Economics I
Mean-Variance (Payoff) Frontier efficient (return) frontier
(1,1,1)
standard deviation expected return
kq
inefficient (return) frontier
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-40
Frontier Returns
Eco 525: Financial Economics I
(if agent is risk-neutral)
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-41
Eco 525: Financial Economics I
Minimum Variance Portfolio
Take FOC w.r.t. of
Hence, MVP has return of
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-42
Eco 525: Financial Economics I
Mean-Variance Efficient Returns
Definition: A return is mean-variance efficient if there is no other return with same variance but greater expectation. Mean variance efficient returns are frontier returns with E[r] E[r0]. If risk-free asset can be replicated
Mean variance efficient returns correspond to 0. Pricing kernel (portfolio) is not mean-variance efficient, since
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-43
Eco 525: Financial Economics I
Zero-Covariance Frontier Returns
Take two frontier portfolios with returns and C The portfolios have zero co-variance if
For all 0 exists =0 if risk-free bond can be replicated
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-44
Eco 525: Financial Economics I
Illustration of MVP
Expected return of MVP M = R2 and S=3
(1,1,1)
Minimum standard deviation
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-45
Eco 525: Financial Economics I
Illustration of ZC Portfolio
M = R2 and S=3 arbitrary portfolio p Recall:
(1,1,1)
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-46
Eco 525: Financial Economics I
Illustration of ZC Portfolio
(1,1,1)
arbitrary portfolio p
ZC of p
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-47
Eco 525: Financial Economics I
Frontier Returns (are on linear subspace). Hence Consider any asset with payoff xj
It can be decomposed in xj = xjE + j q(xj)=q(xjE) and E[xj]=E[xjE], since E. Let rjE be the return of xjE x Using above and assuming 0 and is ZC-portfolio of ,
Mean-Variance Analysis and CAPM Slide 05-48
Beta Pricing
16:14 Lecture 05
Eco 525: Financial Economics I
Beta Pricing
Taking expectations and deriving covariance _
If risk-free asset can be replicated, beta-pricing equation simplifies to Problem: How to identify frontier returns
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-49
Eco 525: Financial Economics I
Capital Asset Pricing Model
CAPM = market return is frontier return
Derive conditions under which market return is frontier return Two periods: 0,1, Endowment: individual wi1 at time 1, aggregate where the orthogonal projection of on M is. The market payoff: Assume q(m) 0, let rm=m / q(m), and assume that rm is not the minimum variance return.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-50
Eco 525: Financial Economics I
Capital Asset Pricing Model
If rm0 is the frontier return that has zero covariance with rm then, for every security j, E[rj]=E[rm0] + j (E[rm]-E[rm0]), with j=cov[rj,rm] / var[rm]. If a risk free asset exists, equation becomes, E[rj]= rf + j (E[rm]- rf)
N.B. first equation always hold if there are only two assets.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-51
Eco 525: Financial Economics I
Outdated material follows
Traditional derivation of CAPM is less elegant Not relevant for exams
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-52
Eco 525: Financial Economics I
Deriving the Frontier
n risky assets
Definition 6.1: A frontier portfolio is one which displays minimum variance among all feasible portfolios with the rp same E (~ ).
1 T min w Vw w 2
( ) ( )
16:14 Lecture 05
s.t. w T e = E w 1=1
T
N w E ( ~) = E ri i i=1 N w = 1 i i=1
Slide 05-53
Mean-Variance Analysis and CAPM
Eco 525: Financial Economics I
The first FOC can be written as:
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-54
Eco 525: Financial Economics I
Noting that eT wp = wTpe, using the first foc, the second foc can be written as
pre-multiplying first foc with 1 (instead of eT) yields
Solving both equations for and
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-55
Eco 525: Financial Economics I
Hence, wp = V-1e + V-11 becomes
CE A 1 B AE 1 V e+ V 1 wp = D (vector) D (vector)
(scalar) (scalar)
1 1 1 1 = B(V 1) A (V e ) + C(V 1e ) A (V 11) E D D
wp = g + h
(vector) (vector) (scalar)
(6.15) linear in expected return E! wp = g wp = g + h
Hence, g and g+h are portfolios on the frontier.
If E = 0, If E = 1,
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-56
Eco 525: Financial Economics I
Characterization of Frontier Portfolios
Proposition 6.1: The entire set of frontier portfolios can be generated by ("are convex combinations" of) g and g+h. Proposition 6.2. The portfolio frontier can be described as convex combinations of any two frontier portfolios, not just the frontier portfolios g and g+h. Proposition 6.3 : Any convex combination of frontier portfolios is also a frontier portfolio.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-57
Eco 525: Financial Economics I
Characterization of Frontier Portfolios
r r r For any portfolio on the frontier, 2 (E[~p ]) = [g + hE (~p )] V [g + hE (~p )]
T
with g and h as defined earlier. Multiplying all this out yields:
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-58
Eco 525: Financial Economics I
Characterization of Frontier Portfolios
(i) the expected return of the minimum variance portfolio is A/C; (ii) the variance of the minimum variance portfolio is given by 1/C; (iii) equation (6.17) is the equation of a parabola with vertex (1/C, A/C) in the expected return/variance space and of a hyperbola in the expected return/standard deviation space. See Figures 6.3 and 6.4.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-59
Eco 525: Financial Economics I
Figure 6-3
16:14 Lecture 05
The Set of Frontier Portfolios: Mean/Variance Space
Mean-Variance Analysis and CAPM Slide 05-60
Eco 525: Financial Economics I
Figure 6-4
16:14 Lecture 05
The Set of Frontier Portfolios: Mean/SD Space
Mean-Variance Analysis and CAPM Slide 05-61
Eco 525: Financial Economics I
Figure 6-5
16:14 Lecture 05
The Set of Frontier Portfolios: Short Selling Allowed
Mean-Variance Analysis and CAPM Slide 05-62
Eco 525: Financial Economics I
Characterization of Efficient Portfolios
(No Risk-Free Assets)
Definition 6.2: Efficient portfolios are those frontier portfolios which are not mean-variance dominated. Lemma: Efficient portfolios are those frontier portfolios for which the expected return exceeds A/C, the expected return of the minimum variance portfolio.
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-63
Eco 525: Financial Economics I
Zero Covariance Portfolio
Zero-Cov Portfolio is useful for Zero-Beta CAPM Proposition 6.5: For any frontier portfolio p, except the minimum variance portfolio, there exists a unique frontier portfolio with which p has zero covariance. We will call this portfolio the "zero covariance portfolio relative to p", and denote its vector of portfolio weights by ZC(p ) . Proof: by construction.
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-64
Eco 525: Financial Economics I
collect all expected returns terms, add and subtract A2C/DC2 and note that the remaining term (1/C)[(BC/D)-(A2/D)]=1/C, since D=BC-A2
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-65
Eco 525: Financial Economics I
For zero co-variance portfolio ZC(p)
For graphical illustration, lets draw this line:
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-66
Eco 525: Financial Economics I
Graphical Representation:
line through p (Var[rp], E[rp]) MVP (1/C, A/C)
AND (use
C A 1 rp rp (~ ) = E(~ ) + D C C
2
for 2(r) = 0 you get E[rZC(p)]
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-67
Eco 525: Financial Economics I
E(r)
A/C MVP
ZC(p) E[r ( ZC(p)]
ZC (p) on frontier
(1/C)
Var ( r )
Figure 6-6
The Set of Frontier Portfolios: Location of the Zero-Covariance Portfolio
Mean-Variance Analysis and CAPM Slide 05-68
16:14 Lecture 05
Eco 525: Financial Economics I
Zero-Beta CAPM
(no risk-free asset)
(i) agents maximize expected utility with increasing and strictly concave utility of money functions and asset returns are multivariate normally distributed, or (ii) each agent chooses a portfolio with the objective of maximizing a derived utility function of the form U (e, 2 ), U1 > 0, U 2 < 0 , U concave. (iii) common time horizon, (iv) homogeneous beliefs about e and 2
16:14 Lecture 05
Mean-Variance Analysis and CAPM
Slide 05-69
Eco 525: Financial Economics I
All investors hold mean-variance efficient portfolios the market portfolio is convex combination of efficient portfolios is efficient. (q need not be on the frontier) (6.22) Cov[rp,rq] = E[rq]+ Cov[rp,rZC(p)] = E[rZC(p)] + =0 Cov[rp,rq] = {E[rq]-E[rZC(p)]} Var[rp] = {E[rp]-E[rZC(p)]} .
E (~ ) = E (~ ( M ) ) + Mq [E(~ ) E (~ ( M ) )] rq rZC rM rZC
Divide third by fourth equation:
(6.28) (6.29)
Slide 05-70
E (~j ) = E (~ ( M ) ) + Mj [E(~ ) E (~ ( M ) )] r rZC rM rZC
16:14 Lecture 05 Mean-Variance Analysis and CAPM
Eco 525: Financial Economics I
Zero-Beta CAPM
mean variance framework (quadratic utility or normal returns) In equilibrium, market portfolio, which is a convex combination of individual portfolios E[rq] = E[rZC(M)]+ Mq[E[rM]-E[rZC(M)]] E[rj] = E[rZC(M)]+ Mj[E[rM]-E[rZC(M)]]
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-71
Eco 525: Financial Economics I
The Standard CAPM
(with risk-free asset)
FOC:
Multiplying by (erf 1)T and solving for yields
w p = V 1 (e rf 1)
nxn nx1 16:14 Lecture 05 nx1
rp E( ~ ) rf H
a number
(6.30)
where H = B - 2Arf + Crf2
Slide 05-72
Mean-Variance Analysis and CAPM
Eco 525: Financial Economics I
NB:Derivation in DD is not correct.
Rewrite first equation and replace G using second equation.
Holds for any frontier portfolio, in particular the market portfolio.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-73