Asset Pricing Theory in One

Lecture
Eric Falkenstein
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Finding Alpha

Capital Asset Pricing Model (CAPM)

Arbitrage Pricing Model (APT)

Stochastic Discount Factor Model (SDF)

General Equilibrium Theory

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Finding Alpha
1. Monopoly power
2. Uncertainty (Frank Knight)
3. Entrepreneur (Schumpeter)
4. Return on Capital

Profits should go to zero over time (Das

Kapital)

Modern Portfolio Theory: Return for bearing

risk
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Diversification, Diminishing Marginal Utility

Processes:

Arbitrage

Equilibrium
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E[Ret
i
]= +E
i
f
Diversification
Decreasing
marginal
utility
U
t
i
l
i
t
y
Consumpti
on
P
o
r
t
f
o
l
i
o

V
o
l
# assets
St. Petersburg Paradox (1738): what is value of
$1 paid if you get a head in a coin flip, where
the payoff is (number of times coin
flipped)^2?
Should be infinity
Why not? Diminishing marginal returns
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1
1 1 1 1
1 2 4 8 ...
2 4 4 16
1 1 1 1
...
2 2 2 2
1
2
j
E
E
E

+ + + +
+ + + +

Jevons, Menger, Walras noted diminishing

marginal utility could explain pricing
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Finding Alpha
( ) ( )
0, 0 U W U W > <
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Johnny Von Neumann and Oscar Mortgenstern 1941 Theory
of Games
Milton Friedman and Savage 1947

Why not put all your wealth in one stock?

To suppose that safety-first consists in

having a small gamble in a large number of
different [companies] strikes me as a
travesty of investment policy.
Keynes
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9
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( )
2
2
~ , , ~ , x N x N
n

| `


. ,
( )
1 2
2 2 2
Var x
x x
Var
| `


. ,
+
Finding Alpha
10
( )
( )
( ) ( )
2
2 2 2
1 1 1
B A AB
vol xA x B x x x x + + +
( )
2 2
2
B A AB
Var A B + + +
Finding Alpha
11
Systematic Risk
Idiosyncratic Risk
n

Total risk; U
ip

2 2
1 1
1
p i ip
N N

| `
+

. ,
2

lim
p ip
N

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risk is variance of return
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13
( )
aW
aW
U e
EU E e

( )
2
2
2
~ ,
a
a
if W N
EU e


| `

. ,


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14
( )
2
U E r a
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15
Standard Deviation
Expected Return
100% investment in security
with highest E(R)
100% investment in minimum
variance portfolio
No points plot above
the red line
All portfolios
on the red line
are efficient
Why we like efficient
portfolios

Portfolio Selection: Efficient Diversification of

Investments (1959)

Markowitz preferred semi-variance in book

Also examines:

standard deviation,

expected value of loss,

expected absolute deviation,

probability of loss,

maximum loss

Prospect Theory in 1952

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Finding Alpha

Levy and Markowitz (1979) show the mean-variance

optimization is an excellent approximation to
expected utility when not-normal

[in the 1960s] there was lots of interest in this issue

for about ten years. Then academics lost interest.
Eugene Fama
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18
Exp
Return
Volatility

U1
U2
U3
Port-
1
Port-
2
Port-
3
U4
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21
Standard Deviation
Expected Return
R
f
A
B
C
( )
1
z f B
z B
R z r zr
z
+

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Finding Alpha
( )
1. every asset has same marg. value
i im
a E r k
( )
2.
f fm f
E r a k k r
( )
( )
2
2
3.
m f
m
m m
E r a k a
E r r

( )
( )
2
4.
i i
m
f
m f
m
E r r
r E r

( ) ( ) ( )
2
5.
im
f m f
m
i
E r r E r r

+
( ) ( ) ( )
6. aka the CAPM the SML
i f m f i
E r r E r r +
Finding Alpha
24
Beta
Expected Return
R
f
Market Portfolio
1.0
E(R)
( ) ( )
where ( ) expected return on security
risk-free rate of interest
beta of Security
( ) expected return on the market
i f i m f
i
f
i
m
E R R E R R
E R i
R
i
E R

]
+
]

% %
%
%
Finding Alpha
25
( ) ( )
'
' '
1
0 1
'
0
U
1. U U 1 1 1
U
E r E r + +
3. [ ] [ ] [ ] cov( , ) 1 E MR E M E R M R +
1
[ ]
c
4.
ov( ,
]
[ ]
[
)
E
M
M
E
R
E M
R
1
5. [ ]
[ ]
f f
R E R
E M

'
1
' '
0 0
'
0
- U
6.
U U
1

cov( , )
' cov( , )
m
m
i m
R
R
M
U M R
R
U
R

'
0
' '
0 1
cov( ,
7.
)
[ ]
i m
f
E
U
R
R R
U U
R
| ` | `
+

. ,. ,
[ ]
'
1
'
0
2. 1 giv
U
U
en M= E MR
'
1
cov( , )
8. [ ]
i m
f
R R
E R R
U

+
cov( , )
11. [ ] [ ]
var( )
i m
i f m f
m
R R
E R R E R R
R
+
12. [ ] [ ]
i f m f
E R R E R R +
'
1
var( )
9. letting R =R
[ ]
m
i m
m f
R
U
E R R

cov( , )
10. [ ]
var( )
[ ]
i m
f
m
m f
R R
E R R
R
E R R

+
]
]

]
]
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Finding Alpha
[ ]
1 E MR
1
1, 2, ,
k
i i ji j i
j
r a b f e i n

+ +

L
1 1 1
' , ,
m
M U
R GDP oil


Total Ut
Margina
l Ut
Wealth
T-bills, MT Tbonds, LT Treasuries, Corp Bonds, Mortgages, Large
Cap Stocks, Large-cap growth stocks, medium cap stocks, small
cap stocks, non-US bonds, European stocks, Japanese stocks

If f is a risk factor, it must have a linear price

to prevent arbitrage

Can of beer: $1

6-pack of beer: $6

Case of beer (24 pack): $24

Price of beer linear in units, else arbitrage

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Finding Alpha
( )
1
1 2 2
Random 'price of risk' 'how much'
,
0
1, 2, ,
~
f i
j j j
j
i i i
b r r f b f e i n
f N

+
>
+ +
142 43 142 43 142 43
L
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28

For k number factors

How many factors? 3? 5? 12?

What are the factors? Empirical issue.

Could be estimated just like a bias

Total Portfolio Volatility no longer the issue

1
1, 2, ,
k
i i ji j i
j
r a b f e i n

+ +

L
( ) ( ) ( ) ( )
f m m f size small big value value growth mo up down i
r r r r r r r r r r + + + +

Markowitz. Normative model: people should

invest in efficient portfolios

No residual aka idiosyncratic aka unsystematic,

volatility

Tobin: Efficient portfolio always combination of

a single risky portfolio and the non-risky asset

Sharpe : Given Tobin, covariance with the

market dictate expected return

Ross: add factors like R

m
-R
f
, whatever matters
to people, linear pricing in factors
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linear in risk factors

not include residual risk

include something very like the stock market

as one of the prominent factors
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