05 CAPM - A

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
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
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
Slide 05-3
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]
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
Overview
Mean-variance analysis
Portfolio Theory (Portfolio frontier, efficient frontier, ) CAPM (Intuition)
CAPM
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.
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
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)
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

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

For -1 < 1,2 < 1:
E[r2]
E[r1]
Efficient Frontier: Two Imperfectly Correlated Risky Assets
16:14 Lecture 05
Slide 05-12
For 1 = 0
E[r2]
p
E[r1]
The Efficient Frontier: One Risky and One Risk Free Asset
Efficient Frontier with

n risky assets and one risk-free asset
The Efficient Frontier: One Risk Free and n Risky Assets

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)
Optimal Portfolio: Two Fund Separation
Price of Risk = = highest Sharpe ratio
Optimal Portfolios of Two Investors with Different Risk Aversion

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
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
Slide 05-18
The Capital Market Line
CML
rM rf
j
M
16:14 Lecture 05 Mean-Variance Analysis and CAPM
p
Slide 05-19
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
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

The Security Market Line

E(r) SML E(ri)
E(rM)
rf slope SML = (E(ri)-rf) / i
M= 1
16:14 Lecture 05
Slide 05-22
Overview
Simple CAPM with quadratic utility functions (derived from state-price beta model) Mean-variance preferences
Portfolio Theory CAPM (Intuition)
CAPM (modern derivation)

16:14 Lecture 05
Slide 05-23
Projections
States s=1,,S with s >0 Probability inner product -norm (measure of length)
16:14 Lecture 05
Slide 05-24
y x
shrink axes
y x
x and y are -orthogonal iff [x,y] = 0, I.e. E[xy]=0

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]

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
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
Slide 05-28
Expected Value and Co-Variance
E[x] = [x, 1]=
16:14 Lecture 05
Slide 05-29
Overview
Mean-variance preferences
Portfolio Theory CAPM (Intuition)
CAPM (modern derivation)

16:14 Lecture 05
Slide 05-30
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
Slide 05-31
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.)
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.
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)
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)
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).
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.
Frontier Returns
Frontier returns are the returns of frontier payoffs with non-zero prices.
graphically: payoffs with price of p=1.

M = RS = R3
Mean-Variance Payoff Frontier
kq Mean-Variance Return Frontier p=1-line = return-line (orthogonal to kq)

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.
Mean-Variance (Payoff) Frontier efficient (return) frontier
(1,1,1)
standard deviation expected return
kq
inefficient (return) frontier
16:14 Lecture 05
Slide 05-40
Frontier Returns
(if agent is risk-neutral)
16:14 Lecture 05
Slide 05-41
Minimum Variance Portfolio

Take FOC w.r.t. of
Hence, MVP has return of
16:14 Lecture 05
Slide 05-42
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
Slide 05-43
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

Illustration of MVP
Expected return of MVP M = R2 and S=3
(1,1,1)
Minimum standard deviation
16:14 Lecture 05
Slide 05-45
Illustration of ZC Portfolio
M = R2 and S=3 arbitrary portfolio p Recall:
(1,1,1)
16:14 Lecture 05
Slide 05-46
Illustration of ZC Portfolio
(1,1,1)
arbitrary portfolio p
ZC of p
16:14 Lecture 05
Slide 05-47
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 ,
Beta Pricing
16:14 Lecture 05
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
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.
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.
Outdated material follows

Traditional derivation of CAPM is less elegant Not relevant for exams
16:14 Lecture 05
Slide 05-52
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
The first FOC can be written as:
16:14 Lecture 05
Slide 05-54
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
Slide 05-55
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
Slide 05-56
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.

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
Slide 05-58

(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.
Figure 6-3
16:14 Lecture 05
The Set of Frontier Portfolios: Mean/Variance Space

Figure 6-4
16:14 Lecture 05
The Set of Frontier Portfolios: Mean/SD Space

Figure 6-5
16:14 Lecture 05
The Set of Frontier Portfolios: Short Selling Allowed

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
Slide 05-63
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
Slide 05-64
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
For zero co-variance portfolio ZC(p)
For graphical illustration, lets draw this line:
16:14 Lecture 05
Slide 05-66
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
Slide 05-67
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

16:14 Lecture 05
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
Slide 05-69
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
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)]]
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
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.


05 CAPM - A

Загружено:

Сведения о документе

Исходное описание:

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

05 CAPM - A

Загружено:

Авторское право:

Доступные форматы

Eco 525: Financial Economics I

Mean-Variance Analysis and CAPM

Eco 525: Financial Economics I

Eco 525: Financial Economics I

Recall State-price Beta model

Mean-Variance Analysis and CAPM

Eco 525: Financial Economics I

Simple CAPM with Quadratic Expected Utility

Eco 525: Financial Economics I

Simple CAPM with Quadratic Expected Utility

E[Rh]=Rf + h {E[Rm]-Rf} Market Security Line

Eco 525: Financial Economics I

Eco 525: Financial Economics I

Definition: Mean-Variance Dominance & Efficient Frontier

Eco 525: Financial Economics I

Expected Portfolio Returns & Variance

recall that correlation coefficient [-1,1]

Mean-Variance Analysis and CAPM

Eco 525: Financial Economics I

Illustration of 2 Asset Case

Eco 525: Financial Economics I

The Efficient Frontier: Two Perfectly Correlated Risky Assets

Eco 525: Financial Economics I

For 1,2 = -1:p

Efficient Frontier: Two Perfectly Negative Correlated Risky Assets

Eco 525: Financial Economics I

For -1 < 1,2 < 1:

Efficient Frontier: Two Imperfectly Correlated Risky Assets

Mean-Variance Analysis and CAPM

Eco 525: Financial Economics I

Eco 525: Financial Economics I

Efficient Frontier with

The Efficient Frontier: One Risk Free and n Risky Assets

Eco 525: Financial Economics I

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

Eco 525: Financial Economics I

Equilibrium leads to CAPM

Equilibrium Demand = Supply (market portfolio) CAPM allows to derive

Eco 525: Financial Economics I

Mean-Variance Analysis and CAPM

Eco 525: Financial Economics I

The Capital Market Line

Eco 525: Financial Economics I

Proof of the CAPM relationship [old traditional derivation]

As varies we trace a locus which

locus at M = r dp =1 = slope of CML = M M f

Eco 525: Financial Economics I

Do you see the connection to earlier state-price beta model? R* = RM

Eco 525: Financial Economics I

The Security Market Line

rf slope SML = (E(ri)-rf) / i

Mean-Variance Analysis and CAPM

Eco 525: Financial Economics I

CAPM (modern derivation)

Mean-Variance Analysis and CAPM

Eco 525: Financial Economics I

Mean-Variance Analysis and CAPM

Eco 525: Financial Economics I

x and y are -orthogonal iff [x,y] = 0, I.e. E[xy]=0