Lecture07

Investment
Theory
Elena
Pikulina
Overview
From
Portfolio
Theory to the CAPM

Investment Theory
The Capital Asset Pricing Model

CAPM: Assumptions and Implications
The CAPM
Equation
SML and
CML

Elena Pikulina
Sauder School of Business
University of British Columbia

Beta and
Alpha

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General Overview
Investment
Theory
Elena
Pikulina
Overview
From
Portfolio
Theory to the CAPM
CAPM: Assumptions and Implications
The CAPM
Equation
SML and
CML
Beta and
Alpha

• In the previous lecture (Portfolio Theory) we studied how to choose a

stock portfolio.
• A crucial input was the expected return of each stock.
• In this lecture (The Capital Asset Pricing Model) we seek to obtain

some insight on stocks’ expected returns.
• How are expected returns determined?
• How are they related to risk?

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Overview of the Lecture
Investment
Theory
Elena
Pikulina
Overview
From
Portfolio
Theory to the CAPM
CAPM: Assumptions and Implications

1

From Portfolio Theory to the CAPM

2

CAPM: Assumptions and Implications

3

The CAPM Equation

4

SML and CML

The CAPM
Equation

5

Beta and Alpha

SML and
CML

6

Applications of the CAPM

7

Alternative Models to the CAPM

8

Statistical Tests of the CAPM

Beta and
Alpha

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From Portfolio Theory to an Equilibrium Model
Investment
Theory
Elena
Pikulina
Overview
From
Portfolio
Theory to the CAPM
CAPM: Assumptions and Implications

• Portfolio Theory
• Optimal individual behavior (portfolio optimization) when returns are given
• No market-wide considerations

• Capital Asset Pricing Model
• Optimal individual behavior (portfolio optimization)
• Market-wide equilibrium determines expected returns

The CAPM
Equation
SML and
CML
Beta and
Alpha

• Why do we need an equilibrium model?
• Suppose an asset offers a stream of risky cash flows in the future. Today’s

price and expected future cash flows will determine the asset’s expected return. • How much are investors willing to pay for this asset today?
• This important question cannot