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EMSE 6450: Investment Science - Leunberger

Chapter 7 : Capital Asset Pricing Model

Lecture Notes by: J. Ren van Dorp"


Faculty Page: www.seas.gwu.edu/~dorpjr

1
Department of Engineering Management and Systems Engineering,
School of Engineering and Applied Science,
The George Washington University, 1776 G Street, N.W. Suite 135,
Washington D.C. 20052. E-mail: dorpjr@gwu.edu, dorpjr@gmail.com

EMSE 6450 : Investment Science - Leunberger Page 1


Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Market Equilibrium
Two main problems dominate Investment Science

Problem 1: Choosing the best investment alternative. For example:


How to devise the best portfolio, How to devise the optimal strategy for
managing an investment. How to select from a group of a potential
investment strategies.

Problem 2: Determing the correct price for an asset. For example:


Bond pricing using term stucture of interest rate, Valuation of a firm.

Capital Asset Pricing Model (CAPM) falls under the second category

but

it arises naturally from Markowitz Mean Variance portfolio theory.

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Market Equilibrium
Suppose: (1) all investors are mean-variance optimizers; (2) all agree
on the parameters (means, variances and covariances); and (3) a unique
risk-free asset exist without fees Everybody invests in risk free
asset and the fund F (recall the one-fund theorem of Chapter 6) If
everybody buys the one fund F then the total of their purchases add up
to the market The fund F is the market fund.

Market Fund: The weights are the market capitalization weights.

Shares Relative shares Capitalization


Security outstanding in Market Price Capitalization Weights
Jazz, Inc. 10,000 1/8 $6.00 60,000 3/20
Classical, Inc. 30,000 3/8 $4.00 120,000 3/10
Rock, Inc. 40,000 1/2 $5.50 220,000 11/20
Total 80,000 1 400,000 1

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Market Line
The single efficient fund J of risky assets under above assumption
shall be labeled Q for market. Its average return will be denoted <Q
and its standard deviation 5Q . The constant return of the risk-free
asset will be denoted <0

One-fund theorem the efficient frontier is the straight line


that connects the points ! <0 and 5Q <Q :
r
rm rf
r= + rf
M M <Q <0
< 5 <0
5Q
rm rf 5Q 5 5
<0 <Q
rf M 5Q 5Q

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Market Line
Observation 1: If one does not want to accept investment risk (5 0)
one has to invests all funds in the risk free asset <0 .

r Observation 2: If one desires


a rate of return of <Q , one has to
invest all funds in the market and
M accept a risk of 5Q .

Observation 3: Return
M < <Q only by investing more
r= rf + rm
rf M M than you have in the stock market.
Thus, one has to borrow money
r at the rate <0 and invest it in the
stock market. This is the short
selling option.

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Market Line
Observation 4: If short selling is not allowed, one cannot get a
higher rate of return than the market return <Q .

Example 7.1 (The impatient investor): Currently <0 '%, <Q "#%
and 5Q "&%.
$" !!! "!''" $" !!! !!!
Thus, it would take about '" years for $" !!! to grow to $" !!! !!!
dollars. This takes too long for Mr. Smith and he would like this to happen
in 10 years.

This would require an (average) rate of return of his investment portfolio of


**&$%. What standard deviation would Mr. Smith have to accept?

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Market Line

Option 1 Option 2
Amount $1,000 $1,000
Rate of Return 12% 99.53%
Number of Years 60.95 10
Future Value $1,000,000.00 $1,000,000.00
Desired Future Value $1,000,000.00 $1,000,000.00

According to the capital market line the standard deviation would be that
value of 5 that satisfies:

<7 <0 !"# !!'


< 5 <0 !**&$ 5 !!'
5Q !"&
!"&
5 !**&$ !!' #$%%
!!'

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Market Line
Recalling
5Q 5 5
< <0 <Q
5Q 5Q
To get a return of **&$% in the first year Mr. Smith has to borrow
5Q 5 !"& #$%
| $" !!!| | $" !!!| $"% &))
5Q !"&
Extra Homework Question:
Assuming Mr. Smith is lucky enough that each year the return of his
portfolio is indeed **&$%. What is the net present value of the cash
flow over this 10 year period that Mr. Smith has to borrow to make that
happen (assume that at the end of each year Mr. Smith pays back the money
he borrowed at the beginning of the year to get that return + interest).

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Market Line
Example 7.2 (An oil venture):
Consider an oil drilling venture. The price of a share of this venture is $875.
It is expected to yield the equivalent of $1,000 after 1 year, but due to high
uncertainty about how much oil is at the drilling site, the standard deviation
of the return is 5 = 40%. Currently, <0 10% <Q 17%, 5Q 12%.
How does this venture compare with assets on the capital market line?
5Q 5 5
< <0 <Q
5Q 5Q
12% 40% 40%
10% 17% $$%
12% 1#%
The rate of return for the venture is
I\" $" !!!
" " "%% $$%
\! $)(&
Conclusion: The oil venture does not constitute an efficient portfolio.

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Asset Pricing Model

-portfolio curve:
{( ( ), r ( )) | r ( ) = ri + (1 ) rM }
Capital market line:
rm rf
r= + rf
M The tangent line of the
r
M -portfolio curve at = 0
rM 5
is the capital market line.
ri 4
i
( (0), r (0)) = ( M , rM )
rf 3

1
i r

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM): If the market port
folio Q is efficient, the expected return <3 of any asset 3 satisfies
<3 <0 53Q
# "3
<Q <0 5Q
where 53Q is the covariance between <3 and <Q . Conclusion:
<3 <0 53Q
<3 <Q " "3 # "
<Q <0 5Q
This is a remarkable result. It says that all we need to know to decide if
the average return of an asset <3 exceeds market performance is the
covariance of that return with the market and the variance of the
market return. Also:
"3 " <3 <Q 53 5Q (Why?)

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Asset Pricing Model
.<
Proof: < <3 " <Q <3 <Q "
.

5 # 53# #" 53Q " # 5Q


#

. 5 53# " #53Q " 57


#
#
. 5
Substitution of ! in # yields

#
. 5 53Q 5Q
l! since 5 ! 5Q $
. 5Q

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Asset Pricing Model
From $ and " we have:
.< .< . .< <3 <Q 5Q
l! #
%
. 5 . . 5 . 5 53Q 5Q
Equation % provides the directional coefficient of the tangent line of the
-portfolio curve in the < -5 diagram at !, which coincides with the
point <Q 5Q in the < -5 diagram. However, according to the one-fund
theorem the capital market line is the tangent line at Q of the efficient
frontier with the directional coefficient:
(<Q <0 )/5Q &
Equating % and & yields:
<3 <Q 5Q <Q <0 <3 <0 53Q
#
# "3
53Q 5Q 5Q <Q <0 5Q

EMSE 6450 : Investment Science - Leunberger Page 13


Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Asset Pricing Model
The value "3 is referred to as the beta coefficient of the asset.

The relationship above can be rewritten as:


<3 <0 53Q <Q <0 53Q
# <3 <0
<Q <0 5Q 5Q 5Q
Recall that for efficient funds < / on the capital market line we have:

<Q <0 5/ 5Q 5/
</ 5/ <0 < / <Q <0
5Q 5Q 5Q

Hence, for these funds we have:


5/Q 5/Q
5/ " 3/Q " </ +<Q ,
5Q 5/ 5 Q

EMSE 6450 : Investment Science - Leunberger Page 14


Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Asset Pricing Model
In other words, for efficient funds the random returns are a linear
combinations of the random market return. Solving for + and , :
</ +<Q , I</ +I</ , </ +<Q ,

5/ 5Q 5/ 5/ 5Q 5/
</ <Q <0 + , <0
5Q 5Q 5Q 5Q
Conclusion: For efficient funds the only source of uncertainty is the
market uncertainty and nothing else (more later).

<3 <0 53Q <Q <0 53Q


Recall: # <3 <0
<Q <0 5Q 5Q 5Q

Expected excess rate of return of asset 3: <3 <0

Expected excess rate of return of market return: <Q <0

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Asset Pricing Model
Observation 1: When 53Q !, the rate of the asset return equals <0
regardless of its risk. The explanation is that by creating a large
portfolio of these assets uncorrelated with the market and uncorrelated
with each other portfolio variance will become small (why?)

Observation 2: 53Q ! <3 <0 even though 53 ! Inclusion


of such an asset in a port-folio reduces portfolio variance and investors
will accept an average return less than <0 for that asset with less risk.

Example 7.3 (A simple calculation): Suppose <0 )%, <Q "#%


and 5Q "&%. What is "3 and <3 when asset 3 has covariance
53Q !!%&
53Q !!%&
"3 # # <3 "3 <Q <0 <0
5Q !"&#

EMSE 6450 : Investment Science - Leunberger Page 16


Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Capital Asset Pricing Model
< 3 "3 <Q <0 <0 # !"# !!) !!) "'%.

Beta of a portfolio:

< A3 <3
8

3"

G9@< <Q A3 G9@<3 <Q


8

3"

A3 G9@<3 <Q
8

A3
8
G9@< <Q 3" G9@<3 <Q
#
# #
5Q 5Q 3"
5 Q

"< A3 "3
8

3"

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
The Security Market Line

ri ri
rm rf i ,m
ri = (rm rf ) i + rf , i = 2
ri = i ,m + rf M
M2
rM M rM M

rf rf

M2 Cov (ri , rm ) 1 i

Security Market Line Plots an assets average return as a function of


53Q or as a function of "3 Note this is different from the Capital
Market Line that relates average return of an efficient asset to its
standard deviation 5< .
EMSE 6450 : Investment Science - Leunberger Page 18
Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Systemic Risk and Non-Systemic Risk
Asset uncertainty is the sum of market uncertainty and residual
uncertainty:

< " < < <


<3 "3 <Q <0 <0 %3 , %3 Error term
I%3 !
3 3 Q 0 0

53Q G9@<3 <Q G9@"3 <Q <0 <0 %3 <Q


#
"3 G9@<Q <Q G9@%3 <Q "3 5Q G9@%3 <Q

# 5
G9@%3 <Q 53Q "3 5Q "3 53Q
# G9@%3 <Q !
Q

Variance of asset uncertainty is the sum of a market variance


term and variance of the residual uncertainty:
Z +<<3 Z +<"3 <Q <0 <0 Z +<%3
Asset Risk Systemic Risk Non-Systemic Risk

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Systemic Risk and Non-Systemic Risk

<3 "3 <Q <0 <0 %3

Systemic Risk "3# 5Q#


, cannot be diversified. non-systemic Risk 5%# ,
can be diversified through portfolio construction.

Assets on Capital Market Line which are efficient) only carry


systemic risk (or market risk). They do not carry non-systemic risk.

Assets not Capital Market Line: Suppose we have a number of assets


that carry the same level of " . According to the CAPM they all have
the same expected return

<3 "3 <Q <0 <0

and hence fall on a horizontal line in a <-5 diagram.

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Systemic Risk and Non-Systemic Risk
r

M
Assets with
nonsystemic risk

rf
Asset with systemic risk only

The more non-systemic risk they carry the more they shift to the
right and this non-systemic risk is not correlated to market
behavior. So where is this uncertainty coming from?

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Investment Implications
Can CAPM help with investment decisions? No easy answer.
Markowitz Solution: Assumes that all that is needed is a market fund
and a risk-free asset.

Market Fund: A fund with all available assets with proportions equal
to their market capitalization weights. Hard to do for an individual.

Index Funds: Serve as a "market fund". A mutual fund designed to


match the market portfolio closely.

CAPM purist: Purchase one of these index funds and some risk-free
securities such as US treasury bills.

CAPM non-purist: CAPM assumes everybody has the same


information. This is not the case. If one believes one has superior info
one presumably could design a portfolio that outperforms the market.

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Performance Evaluation

ri Jensen index r Sharpe index


ABC
rABC
ABC
M rM
M
rM

ABC (rM rf ) + rf (rABC r f )

rf
rf

1 M ABC
rABC rf
J = rABC { ABC (rM r f ) + r f } S = tan( ) =
ABC
Caution: For some N ! means ABC performs well, for others it
measure inaccuracy due to small sample size, and for yet others it
measure invalidity of CAPM model.
EMSE 6450 : Investment Science - Leunberger Page 23
Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Performance Evaluation - Example
Example 7.4 (ABC fund analysis):
Rate of Return Percentage

Jensen Index ABC Fund: Year


1
ABC
14%
S&P
12%
T-Bills
7%
NEFG !!!"!% Hence, ABC 2 10% 7% 8%
3 19% 20% 8%
fund can be thought of as a well 4 -8% -2% 8%
performing fund. 5
6
23%
28%
12%
23%
9%
8%
7 20% 17% 7%
8 14% 20% 7%
Sharpe Index ABC Fund: 9 -9% -5% 8%
WEFG !%$&(( whereas 10
Average
19%
13.0%
16%
12.0%
8%
7.6%
WW &T &!! !%'''* Hence, Standard Deviation 12.4% 9.4% 0.5%
since WEFG WW &T &!! it is not Geometric Mean 12.3% 11.6% 7.6%

an efficient fund as revealed by Cov(ABC, S&P)


Beta
0.01070
1.20375 1
the data. Jensen 0.00104 0.00000
Sharpe 0.43577 0.46669

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Performance Eval. - Statistical Estimation
Average Rate of Return: Given observations <3 3 " 8

s< <3 I s< < Z +< s< 5 # 8


" 8
8 3"

Variance Rate of Return: Given observations <3 3 " 8

<3 s<# I=# 5 # Z +<=#


8 %
" # 5
=#
8 " 3" 8"

Geometric Mean: Given observations <3 3 " 8

. " <3 " V3


8 "8 8 "8
"
3" 3"

EMSE 6450 : Investment Science - Leunberger Page 25


Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Performance Eval. - Statistical Estimation

Covariance of Rate of Return with Market: Given observations


<3 3 " 8 and observations <Q 3 3 " 8

<3 s<<Q 3 s< Q


8
"
G9@< <7
8 " 3"

Beta of Rate of Return:

"
8
8" <3 s<<Q 3 s< Q
G9@< <Q 3"
"
" 8
Z +<<Q s< Q #
8" <Q 3
3"

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
CAPM as a Pricing Formula
What should be the current price : be of a random payoff U in the
future with average payoff U and beta coefficient " ? We have
U: U U
< "< " " <Q <0 <0
: : :
Pricing formula of the CAPM:
U
:
" <Q <0 <0 "
When assets payoff U is deterministic " !:
U
: i.e. price reduces to the familiar discounting formula
<0 "

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
CAPM as a Pricing Formula

Example 7.5 (The price is right):


Gavin is thinking about investing in a mutual fund (institutional portfolio).
This fund invests "!% of its funds at the risk-free rate <0 and the remaining
*!% in the market portfolio. Currently, <0 (%, <Q "&% One share of
the fund costs $"!!. Is this the right price?
<3 <0 " <Q <3 !"! !!( !*! !"& !"%#

To evaluate the price we need U and "3

" U $"!! " <3 $""%#!

<3 <0 <0 "<Q <0


# "3 <Q <0 <Q <0 " "3 !*!

U ""%#!
" # : " <Q <0 <0 " !*!!"&!!(!!(" $"!!.
EMSE 6450 : Investment Science - Leunberger Page 28
Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
CAPM as a Pricing Formula

Example 7.6 (The oil venture):


Consider an oil drilling venture. The price of a share of this venture is $875.
It is expected to be equivalent to $1,000 after 1 year i.e. U $" !!!
Currently, the standard deviation of the return < is 5 = %!%, " !',
<0 "!% and <Q "(%. What is the value of a share based on CAPM?

U $1000
: $)('.
" <Q <0 <0 " !'!"( !"! !"! "
Note that 5 = %!% does not enter the calculation, but 53Q does via " .

Relationship " , : and U


U: " G9@< <Q G9@U <Q
< U"" #
#
: : 5Q : 5Q

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Certainty Equivalent Formula
Using the fact that
U U
: : G9@U<Q

" <Q <0 <0 " # <Q <0 <0 "
:5Q

U
G9@U<Q
"
#
5Q
<Q <0 :<0 "
G9@U <Q <Q <0
#
:<0 " U
5Q

U
" G9@U <Q <Q <0
: #
" <0 5Q

Certainty Equivalent : Recalling the standard discounting formula the


term in brackets is called The Certainty Equivalent of the random U.

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Certainty Equivalent Formula
Linearity of Pricing :

U"# U" U# U"# U" U#

and G9@U"# <Q G9@U" <Q G9@U# <Q

U"#
" G9@U"# <Q <Q <0
:"# #
" <0 5Q

U" U#
" [G9@U" <Q G9@U# <Q ] <Q <0
#
" <0 5Q

U"
" G9@U" <Q <Q <0
#
" <0 5Q

U# : " :#
" G9@U# <Q <Q <0
+ #
" <0 5Q

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Certainty Equivalent Formula
Example 7.7 (Gavin tries again The Price is Right):
Gavin is thinking about investing in a mutual fund (institutional portfolio).
This fund invests "!% of its funds at the risk-free rate <0 and the
remaining *!% in the market portfolio. Currently, <0 (%, <Q "&%
One share of the fund costs $"!!. Is this the right price?
U
<3 " <3 " <Q <0 "3 "
"!!

G9@U <Q #
"3 #
G9@U <Q $ "!! " 5 Q
$"!! 5Q
Thus

U
#
" $"!! " 5Q <Q <0
: #
" <0 5Q

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Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr
Certainty Equivalent Formula
Thus:

U $"!! " <Q <0


"
:
" <0
$""%#! $"!! " !"! !"& !!(
"

"!(
$"!(
$"!!
"!(
Conclusion:

The Certainty Equivalent of the risky average $""%#! is a sure $107

Homework: Extra Homework, 7.2, 7.6, 7.8

EMSE 6450 : Investment Science - Leunberger Page 33


Chapters 7 : Capital Asset Pricing Model Notes by J. Rene van Dorp
Adapted from notes by: Sleyman zekici, Department of Industrial Engineering, Ko University www.seas.gwu.edu/~dorpjr