Investments

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7 Terms

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Financial markets

Financial markets facilitate the allocation of resources:

  • across time, by allowing economic agents to save and borrow

  • across states of the world, by allowing risks to be shared and transferred


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MPT versus CAPM

Key insight: CAPM closes the loop by imposing that observed prices

are equilibrium prices

Equilibrium: a situation where all investors are satisfied with their

holdings and do not want to change anything

MPT needs estimates of expected returns (notoriously hard); CAPM

predicts them from β

<p>Key insight: CAPM closes the loop by imposing that observed prices</p><p class="p1">are equilibrium prices</p><p class="p1">Equilibrium: a situation where all investors are satisfied with their</p><p class="p1">holdings and do not want to change anything</p><p class="p1">MPT needs estimates of expected returns (notoriously hard); CAPM</p><p class="p1">predicts them from β</p>
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Why Must the Tangency Portfolio Be the Market Portfolio?

In equilibrium, aggregate demand must equal aggregate supply
Hence, in CAPM equilibrium, the market portfolio is the tangency portfolio

and is therefore mean-variance efficient

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Slope of the CML

The CML equation is essentially the Sharpe ratio written as a linear

pricing rule

The slope of the CML is (︁rM− rf )︁/σM , i.e., an investor considering a

marginally riskier efficient portfolio would obtain an increase in

expected return of (︁rM− rf )︁/σM

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Capital Asset Pricing Model (CAPM)

is an equilibrium theory

relying on MPT, but with a somewhat peculiar structure

1 The CAPM is a theory of financial equilibrium only, it does not link

returns with the real economy

2 It assumes that the observed asset prices are equilibrium prices, i.e., the

supply equals demand, without calculating asset supply or demand

explicitly


3 The CAPM expresses equilibrium in terms of relationships between the

return distributions of individual assets and those of the portfolio of all

assets

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An investment transfers resources from the present to the future

Because the future is uncertain, its pay-off may differ across possible

states of the world

The value of an investment therefore depends on:


  • the size of its future pay-offs

  • the timing of those pay-offs

  • the states in which those pay-offs occur

  • and how investors value resources in those states Consequently, two investments with the same expected pay-off need not have the same price


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