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Understanding Asset Pricing Theory: Key Concepts & Models

Dive into asset pricing theory with a comprehensive overview of CAPM, APT, SDF, and more. Learn about risk aversion, efficient portfolios, market equilibrium, and the factors influencing asset returns.

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Understanding Asset Pricing Theory: Key Concepts & Models

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  1. Video 2 Asset Pricing Theory in One Lecture Eric Falkenstein Finding Alpha

  2. MBA Course in 45 Minutes • Capital Asset Pricing Model (CAPM) • Arbitrage Pricing Model (APT) • Stochastic Discount Factor Model (SDF) • General Equilibrium Theory Finding Alpha

  3. What Causes Profits? What Causes Returns? Puzzle. • Monopoly power • Uncertainty (Frank Knight) • Entrepreneur (Schumpeter) • Return on Capital • Profits should go to zero over time (Das Kapital) • Modern Portfolio Theory: Return for bearing ‘risk’ Finding Alpha

  4. Two Basic Ideas • Diversification, Diminishing Marginal Utility • Processes: • Arbitrage • Equilibrium E[Reti]=+Eif Portfolio Vol Utility Consumption # assets Decreasing marginal utility Diversification Finding Alpha

  5. Marginal Utility 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 Finding Alpha

  6. Marginal Revolution 1860s • Jevons, Menger, Walras noted diminishing marginal utility could explain pricing Finding Alpha

  7. Diminishing Marginal Utility Necessary and Sufficient Condition for Risk Aversion Johnny Von Neumann and Oscar Mortgenstern 1941 Theory of Games Milton Friedman and Savage 1947 Finding Alpha

  8. Markowitz • 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 Finding Alpha

  9. Law of Large Numbers Finding Alpha

  10. Convex Hull of Investment Possibilities Finding Alpha

  11. Only Covariance Matters for large portfolios  Total risk; U Idiosyncratic Risk Systematic Risk n Finding Alpha

  12. Markowitz: Should Invest in Portfolios, not single asets ‘risk’ is ‘variance of return’ Finding Alpha

  13. Why utility cares about variance, not volatility Finding Alpha

  14. Iso-Utility Curves for Return and Volatility Finding Alpha

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

  16. 'New' ideas there from start • 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 Finding Alpha

  17. Normality? • 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

  18. Tobin: Two-Fund Separation Theorem Exp Return Port-1 U1 U2 Port-2 U3 U4 Port-3 Volatility Finding Alpha

  19. There exists a unique portfolio of risky assets that maximizes utility Finding Alpha

  20. Regardless of risk preference, everyone uses same risky portfolio Finding Alpha

  21. Always hold some cash: liquidity preference Expected Return C B Rf A Standard Deviation Finding Alpha

  22. Sharpe: How do asset returns relate to efficient frontier? Finding Alpha

  23. The Capital Asset Pricing Model Finding Alpha

  24. Security Market Line (SML) Market Portfolio Expected Return E(R) Rf 1.0 Beta Finding Alpha

  25. General Equilibrium aka Stochastic Discount Factor  CAPM Finding Alpha

  26. APT and SDF: use similar logic to generate arbitrary factors Total Ut Marginal 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 Finding Alpha

  27. Arbitrage Pricing Theory • 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 Finding Alpha

  28. APT and Behavioral Finance • 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 Finding Alpha

  29. Asset Pricing Theory • 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 Rm-Rf , whatever matters to people, linear pricing in factors Finding Alpha

  30. Hope for Final Theory • linear in risk factors • not include residual risk • include something very like the stock market as one of the prominent factors Finding Alpha

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