Economics 434: The Theory of
Financial Markets
Professor Burton
Fall 2016
October 13, 2016
Readings
• Chapters 1-9 – available on Collab
• So far, all 9 chapters plus “Random Walk Down
Wall Street”
October 13, 2016
The Capital Asset Pricing Model
• Markowitz – mean, variance analysis
• Tobin – the role of the risk free rate
• Sharpe (and others) – beta and the market
basket
September 15, 17, 2015
Main Conclusion of Markowitz Theory
Mean
Boundary of “feasible” portfolios
“Efficient” Portfolios
σ
September 15, 17, 2015
Tobin’s Result
Mean
Use of Leverage
E
Risk Free
Asset
Standard Deviation
The Capital Asset Pricing Model
• Markowitz – mean, variance analysis
• Tobin – the role of the risk free rate
• Sharpe (and others) – beta and the market
basket
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)
CAPM – two conclusions
Bill Sharpe
• M – the “efficient” basket
• The pricing rule based upon “beta”
Capital Market Line
Mean
M
Rf
What is M ?
Answer: contains all “positively”
priced assets, weighted by their
“market” values.
STDD
Security Market Line
i = Rf + i [M – Rf]
Mean
i
M
Rf
Security Market Line
1
Beta
Things to think about
• Beta is not volatility
• Beta can be negative
• M contains everything of value, weighted by
market value
• Excess return ≡ E[R] – Rf
• “Beta equation” relates excess returns
October 13, 2016
How do you test this theory
• You need M
• Or some proxy for M
• Usually S&P500 or Russell 3000 used as a
proxy for M in beta calculations
October 13, 2016
Richard Roll’s Critique (1977)
• Using a proxy for M won’t work
• CAPM could be false
– But the proxy might make it look true
• CAPM might be true
– But tests using the proxy might make it look false
• Conclusion: theory is not testable unless you have the true M
October 13, 2016
October 13, 2016