Lecture 4: CAPM

Readings:
Ingersoll Chapter 4
Huang & Litzenberger Chapters 3, 4
Roll A Critique of the Asset Pricing Theorys Tests, Journal of Financial
Economics, 1977 be sure and read the appendix
1
What we want to do here is build some intuitions by presenting a special case of more general
future results on the risk/return relation.
Mean-Variance Analysis: The basis for an equilibrium pricing relation known as the Capital
Asset Pricing Model (CAPM) which relates a measure of the risk of an asset to the expected
return of that asset.
Foundation: The risk of a portfolio can be measured by the variance of that portfolios return.
The idea is that there is a derived utility function over mean return and variance of return so that
these two parameters completely determine expected utility ) , ( )] ( [
2
p p
z v z u E where
generally we think that v
1
> 0 and v
2
< 0. This second condition is necessary for consistency with
the maximization of expected utility, the first, in the absence of a riskless asset, is not.
Notation: The matrix Z again represents our market: or we can use the random vector z
~
.
Note: if there exists a riskless asset, it is not included in Z, we keep track of it on the side. z is
a vector of expected returns and is the variance-covariance matrix of Z. For any portfolio w:
Expected Returns:

+
N
i
i i o w
z w R w z w z
0
;
R z
o

;

N
i
i
w
0
1
Variance of return:


N
i
N
j
ij j i w
w w w w
1 1
2

Covariance Vector:
w
w

Given our derived mean/variance utility function, our problem is to describe the mean-variance
efficient set of portfolios: the set of portfolios with the largest mean for a given level of variance.
Any agent with such a utility function will choose a portfolio from this set.

Mean-Variance Efficient Portfolios

2

We will find that it is easier to work with the larger set the minimum-variance portfolios the
set of portfolios with the smallest variance (or std. dev.) for each given level of expected return.

Minimum Variance Portfolios

2

2
We first consider the problem of deriving the minimum variance set in the absence of a riskless
asset.
To derive the minimum variance set we minimize (by choice of a portfolio w) portfolio variance
(a quadratic function of w) subject to the linear (in w) constraints that the portfolios expected
return be at a given level and the budget constraint. The problem is nicely behaved and the first-
order conditions are necessary and sufficient due to this special structure. Symbolically:
Min
w
w w (objective is quadratic in w)
subject to 1w = 1 () (budget constraint linear in w)
w z
() (a fixed expected return linear in w)
Lagrangian:
L =
) ( ) 1 1 ( w z w w w + +
FOCs:
(1) 0 1 *

z w
w
L

(2) 1 * 1

w
L

(3)

* w z
L
Rewrite (1)
(1) w* = z
1 1
1

+ (note this is really w
*
())
Now solve for () and () (the whole problem is based on a given )
(2) z w
1 1
1 1 1 1 * 1

+
(3) z z z w z
1 1
1 *

+
Define: 0 1 1
1
>

A z B
1
1


0
1
>

z z C 0
2
> B AC (as long as

1 k z
)
so, (2) 1 = A + B (3) = B + C

B C
) (

B A
) (
3
4
This lets us find the equation of the minimum variance set.
) (
2
= ) 1 ( * * *
1 1
z w w w

+
=
z w w * 1 * +
=
+
Substituting for and and rearranging we find:
) (
2
=

+ C B A 2
2
.
This is the equation of a parabola in (, ) space. If we write this equation as is a function of
, i.e. in (, ) space, it is the equation of a hyperbola.

g
w

Now we want to locate a specific portfolio or two. We can locate the global minimum variance
portfolio by noting that this portfolio solves the minimization problem with a slack return
constraint: = 0.
From w* = z
1 1
1

+ , if = 0, then
1
1

g
w
. Also, 0

B A
g

or,
. 0 B A
g

So,
A
B
g

. Thus, B > 0 iff
0 >
g

, which is what we think of as the

typical case.
If
A
B
g

then
A
1

, which we find from either
g
B C

or from
. 1 1
g
w

So, we have:
1 1
1 1
1
1 1

A
w
g
,
A
B
g
, and
A
g
1
2
from w
g
w
g
.
Alternatively, we take the derivative of the variance equation to find its unconstrained minimum:
0
2 2 2
2 2

1
]
1

B A c B A

at
g
.
A
B
g

5
Then,
A B AC
A
B
C
A
B
C
B C 1
2
2 2

B B B A
and,
1 1
1
1
1
1
1 1

+ z w
g
as before.
Two Fund Separation:
From z w
1 1
1 *

+ we can see that all minimum variance portfolios can be formed
through portfolio combinations of 2 distinct portfolios. Since w
g
corresponds to one of these
portfolios, it is natural to look at the other one implicit in the equation for w*.
That is, define
B
z
z
z
w
d
1
1
1
1

then, w* =
d g
w B w A ) ( ) ( +
and
1w* = 1 = 1 1 ) ( 1 ) (
2

+
+ +
B AB AB AC
B A w B w A
d g


which verifies the proposition. Note that varying (-, ) and observing that and are
monotonic (linear) functions of also shows that all portfolio combinations of w
g
and w
d
are
minimum variance portfolios.
We just saw that all min-var portfolios are portfolio combinations of w
g
and w
d
and all portfolio
combinations of these portfolios are min-var portfolios. If investors want to hold any min-var
portfolio they dont need access to all tradable assets; they only need access to 2 mutual funds,
w
g
and w
d
.
w
g
is the global minimum variance portfolio can we similarly locate w
d
?
w
d
has expected return:
B
C
B
z
z w z
d d

w
d
has variance of return:
2 2
1
2
1 1 1
2
B
C
B
z z
B
z z
B
z w
w w
d
d d d

We verify that w
d
is a min-var portfolio by checking that it satisfies the equation: +
2
B
C B A B C
B
C
d d
d

+


2
=

+ C
B
A C
C C
2
2
=
2 2
2
) (
B
C
B
B AC C

6
Further, we know that w
d
is on the upper limb of the hyperbola (in the normal case) since:
AB A
B
B
C
z z
g d

We know that A & > 0
so
g d
z z
is positive if B > 0. This is true if
g
> 0 which is normal.
We may also use any two distinct min-var portfolios in place of w
g
and w
d
they will sketch
out or span the entire min-var set, i.e. the minimum variance set is derived from portfolio
combinations of any two distinct minimum variance portfolios.
Let w
a
and w
b
be defined as: w
a
= aw
g
+ (1-a)w
d
w
b
= bw
g
+ (1-b)w
d
w
a
and w
b
are min-var portfolios since they are portfolio combinations of w
g
and w
d
by
construction.
From w* = Aw
g
+

Bw
d
we can get:
w* =
b a
w
a b
A a
w
a b
b A

+ 1 1
by solving the equations for w
a
and w
b
for w
g
and w
d
and substituting these into the equation for
w* and remembering that A +

B = 1.
Since the coefficients on w
a
and w
b
sum to one, the proposition is proved.
The portfolio weight of any asset is linear in

along the min-var frontier. So, as we increase

, the portfolio weight on any asset either linearly increases or decreases when we stay in the set
of minimum variance portfolios.
w* =
d g
Bw Aw +
=
d g
w
B AB
w
AB AC

2

=
d d g g g
w
B
w
AB
w
AB
w
B
w
B AC

2 2 2

= ) (
) (
2
g d g
w w
B AB
w

+

So,
w
i
* = ) (
) (
2
ig id ig
w w
B AB
w

+

If B > 0 and since

0, so
0 B A
, assets represented more heavily in w
d
than in w
g
are
held in larger and larger amounts in min-var portfolios as we increase

above
g

.
Also note that for each asset there is one min-var portfolio in which it has zero weight. In all
portfolios below (above if w
id
-w
ig
is negative) it is sold short.
Covariance Properties of the Min-Var Portfolios:
7
Consider w
g
: if w
g
has different covariances with 2 distinct portfolios, then some combination of
the three will have a lower variance than does w
g
itself. But, we know this cant happen. So, w
g
must therefore have the same covariance with every asset or portfolio.
Consider any portfolio, w
p
. Then,
Cov(z
wg
, z
wp
) = 0
1
1 1
1
1 1
1
1 1
1
>

A
w w w
p p g
This is true for any asset or portfolio. Note 1/A is also w
g
s covariance with itself (i.e. its
variance).
Consider any two min-var portfolios: w
a
= (1-a)w
g
+ aw
d
and w
b
= (1-b)w
g
+ bw
d
(without loss
of generality). Lets assume a 0 and b 0 so we are not looking at w
g
in either case.
dg d g b a
a b b a ab b a z z Cov )] 1 ( ) 1 ( [ ) 1 )( 1 ( )
~
,
~
(
2 2
+ + +
=
A
ab b a
B
C
ab
A
b a
1
) 2 (
1
) 1 )( 1 (
2
+ + +
=
ab
AB
ab
A

+
2
1
This is the covariance between any two min-var portfolios, it is completely determined by the
choice of a and b.
Fix any a 0 (again so w
a
w
g
) by choosing b we can get
ab

to be any value in (
,
), thus,
moving b you pass through zero:
0 =

+
2
1
AB
ab
A
+ ab B
2
0
or,

a
B
b
2
a 0 (recall 0 only if 1 k z )
So, if a > 0 then b < 0, and if w
a
is on the upper limb of the hyperbola, then the min-var portfolio
with a zero covariance with w
a
is on the lower limb and vice versa.
Look at where w
g
and w
d
are and the weight on w
d
implied by a > 0 and b < 0.
In fact, it can easily be shown, by finding the slope of the frontier at a particular point and
finding the interception of the tangent line with the z axis, that the expected return on a portfolio
with zero covariance with a frontier portfolio is located at this interception.
Try this for w
d
for homework.
8
The covariance of a min-var portfolio with any other asset or portfolio:
Cov(z
m
, z
p
) = ? Let w
m
= mw
g
+ (1-m)w
d
w
p
is any asset or portfolio. Then,
Cov(z
m
, z
p
) =
p m
w w

=
p d p g
w w m w mw

) 1 (
=
p
w
z
z
m
A
m

1
1
1
) 1 (
=
B
z
m
A
m
p
) 1 ( +
Thus, the covariance of the return on any asset or portfolio
p
z
~
with the return on a min-var
portfolio
m
z
~
is a function of the expected return on the arbitrary portfolio alone (and, of course,
which min-var portfolio is chosen). Picture!
Comes from
g
=
A
1
and
d
=
B
z
B
z

1
so for any portfolio p with 1w
p
= 1 we see that

pd =
B
z
p

and (of course)
pg
=
A
1
. The covariance of the return on any min-var portfolio and
any other portfolio is some combination of these two covariances.
With a Riskless Asset:
When we assume that there is a riskless asset in the economy, we change the minimization
problem in two ways: we express expected returns in terms of excess returns; and, it is also
convenient to consider that there is no budget constraint for investment in the risky assets the
balance can always be made up of borrowing or lending via the riskless asset.
Write the Lagrangian as:
L = ) ) 1 ( ( w R z R w w + Note: no budget constraint for choice of w
FOCs:
(1) 0 ) 1 ( *

R z w
w
L

9
(2)
R w R z
L

* ) 1 (
(1) w* = ) 1 (
1
R z

we also require w
o
* = 1-1w*
Solve for

using * ) 1 ( w R z R so,

solves
) 1 ( ) 1 ( * ) 1 (
1
R z R z w R z R


Then, ) 2 (
2
A R RB C R + , using our existing definitions for A, B, and C.
The equation of the min-var set is:
) 1 ( * * *
1 2
R z w w w


= ) 1 ( * R z w
=
) ( R
So,
A R RB C
R
2
2
2
2
) (
+

, again a parabola in (
2
, ) space
In (
,
) space this is:
2
1
2
] 2 [ A R RB C R + t
,
a pair of rays originating at R:

Mean-Variance Efficient Set

Capital Market Line
R

Once again, all min-var portfolios are portfolio combinations of any 2 min-var portfolios. One
natural choice is, of course, the riskless asset, and for the other, use the frontier (min-var)
portfolio that includes none of the riskless asset. (How do we know that there is one and only
one? How would you prove this?) This risky asset only portfolio on the min-var frontier is
called the tangency portfolio.
10
w
ot
= 0 so, w
t
=
AR B
R z

) 1 (
1
from 1w
t
= 1
The expected return and variance of return of this portfolio are:
AR B
BR C
AR B
z R z z
w z z
t t

1
1 1
2
2
2
) (
2
AR B
A R RB C
w w
t t t

The interesting, but not surprising result, is that w
t
is also on the risky asset only frontier. We
can use
t
z
and
2
t
to show this.
On the risky asset only frontier we know: +
2
2
t
=
2
2
) (
2
AR B
A R RB C

+
=
) (
) (
AR B
BR C

+
=

,
_

,
_

,
_

AR B
BR C
B
AR B
BR C
A
AR B
BR C
B C
2
)
=
2
2 2
) (
) ( ) )( ( 2 ) (
AR B
BR C A AR B BR C B AR B C

+
=
2
2
) ( AR B
BR C BR AR

+
, which is
2
t
.
w
t
is the portfolio on the risky asset frontier whose tangent line hits the z axis at R,
i.e. w
t
is in both min-var sets.

t
z

t
w

A
B

g
w

R
11
This is the picture for the case
g
z A B R <
. Why do we think this is natural? If A B R > , the
tangency is between the lower limb of the hyperbola and the lower ray. Agents hold the riskless
asset and are long (short) w
t
if R < (>) A B .
Any portfolio on the pair of rays can be formed from portfolio combinations of the two portfolios
w
t
and the risk free asset called 2 fund money separation.
What if R = A B ? No tangency:
A
B
R
Use w*= ) 1 (
1
R z

= ) 1 (
1
A
B
z

= ) 1 (
2
1
2
A
B
z
A R RB C
R

+

Look at 1w*:
=
,
_

,
_

1 1 1
2
1 1
2
A
B
z
A R RB C
R
=
0
2
2

,
_

A
A
B
B
A R RB C
R
Thus, 1w* = 0 so w
o
* = 1. We see agents holding the riskless asset and an arbitrage portfolio of
the risky assets.
Covariance Properties of Min-Var Portfolios with a Riskless Asset
When there is a riskless asset the min-var portfolios are all levered positions in the portfolio w
t
,
so all such portfolios w
a
= k w
t
for some constant k (recall 1' w
a
1). The covariance properties
12
are simple in this case. First note this implies that all the minimum variance portfolios are
perfectly correlated. Secondly, we see that (again) the covariance between any asset or portfolio
and a min-var portfolio is determined by the expected return of the asset or portfolio in question:
AR B
R z
w
t t

) 1 (

and
AR B
R z
AR B
R z
w w w
p
p t p p t

) 1 (
' '
,

for any w
p
such that 1w
p
= 1.
Since in the presence of a riskless asset all the min-var portfolios are perfectly correlated, the
same (scaled) result holds for them (substitute the relation w
a
= k w
t
).
Where does all this math get us?
The Expected Returns Relation:
When there is a riskless asset, it is straightforward to show that the expected excess return on any
asset is proportional to its covariance with
t
z
~
the return on the tangency portfolio. Lets see how
this works.
t t
w
is the vector of covariances of the returns on the individual assets with the return
t
z
~

since the covariance of a random variable with a weighted sum of random variables is the
weighted sum of the individual covariances.
Substitute the equation for w
t
to see:
AR B
R z
AR B
R z
w
t t

1 ) 1 (
1
.
Premultiply this by w
t
to find (note this says the variance of
t
z
~
is made up of the weighted sum
of the covariances of
t
z
~
with the returns on the individual assets nicely reminding us about the
contribution each asset makes to the variance of
t
z
~
):
AR B
R z
AR B
R z
w w w
t
t t t t

) 1 (
2

Then:
R z
R z
t
t
t

1
2

( ) ) ( ) ( 1
2
R z R z R z
t t t
t
t

Or, for each asset:

) ( ) (
2
R z R z R z
t it t
t
it
i

or
) ( R z R z
t it i
+
The story I always tell my MBA students goes like this: The market pays you for two things (1)
surrendering your capital (delaying consumption) for which you get the rental rate R and (2)
13
taking a part of the total or aggregate risk that the market must distribute across all investors (in
this model aggregate risk is measured by
2
t
, why?) for which you get a risk premium. Thats
what this equation says. And in particular your risk premium is determined not by the risk you
hold but rather you get paid for the portion of the aggregate risk you hold. This is determined by
the beta and the excess return on the tangency portfolio is the price per unit risk.
Because, when there exists a riskless asset, all min-var portfolios are perfectly correlated with the
tangency portfolio (each is just a blend of the riskless asset and the tangency portfolio), exactly
the same result holds for every min-var portfolio (any portfolio on the rays).
When there is no riskless asset, then we can use any min-var portfolio and a special companion
for it to most simply express expected returns.
Recall:
A
w
g
1
1

B
z
w
d
1

Let
d g a
aw w a w + ) 1 (
a 0, a 1
z
B
a
A
a
w
a a

,
_

+
,
_

1
1

and,
B
z a
A
a
w w
a
a a a
+
,
_

1
2

For any other portfolio w

p
(not-necessarily min-var, we require only that it be a positive
investment portfolio, 1w
p
= 1), we find the covariance:
B
z a
A
a
w w
p
a p pa
+
,
_

1
.
As we saw before, the correlation of any asset/portfolios (p) return with a frontier portfolios
return is a function of the portfolios (ps) expected return. Reversing this interpretation, this
indicates that
p
z
is a linear function of
p
z
~
s covariance with any min-var portfolio.
Solve the equations for
2
a
and
pa

for
A
a) 1 (
and
B
a
, substitute the resulting relations into
a

:
a
ap a
p a
ap a
ap a a p
z z z z
z

2 2
2
1
Now, make a clever choice of p make it a portfolio (could be the frontier portfolio although
this is not necessary) with a zero covariance with a (i.e.
pa

= 0). Then, the above simplifies to:

) ( 1 ) ( 1
2
z a a z z a
a
a
z
z z z z z z z + +

the subscript z is for zero beta portfolio.

14
Thus, when there is no riskless asset, expected returns are linearly related to an assets beta with
a reference portfolio if that reference portfolio is a minimum variance portfolio.
z

a
z

a
w

g
w

z
z
z
w

This looks like the Black CAPM named for Fisher Black.
A special case is w
d
. Since w
d
is located as it is (with 0
z
z ), if w
d
is used as the reference
portfolio (a = 1 above), it must be that
d d
z z
. We can verify this using
B
z
w
d
1

.
Then,
B
z
d
, and
B
z
d
d

2

d d d
d
d
z z z

2
.
We have shown that if the reference portfolio is a min-var portfolio, the expected return on any
asset is a linear function of the covariance between that assets return and the return on the
reference portfolio.
Important point: The linearity property of expected returns and beta or covariance holds only if
the benchmark portfolio is in the min-var set.
Proof: Assume
p p
w z + + 1 1
for an arbitrary portfolio p with 1w
p
= 1
Then:

1
1
1 1

z w
p
=
g d
w w +
Since 1w
p
= 1,
1 +
and w
p
is a portfolio combination of w
g
and w
d
and so is in the min-var
set. So, the vector of expected returns is linear in the betas with a reference portfolio if and only
if the reference portfolio is a minimum variance portfolio. Roll critique.
Variance Decomposition
The expected returns relation is telling us that only a part of an individual assets variance (or
risk) is priced, only that part that covaries with the return on a min-var portfolio. It is instructive
to decompose the variance of any asset or portfolio to see just how this happens. For any
portfolio w
p
let w
m
be the min-variance portfolio with the same expected return. Write:
) ( ) (
m p g m g p
w w w w w w + +
=
d s g
w + +
,
where
s

and
d

are arbitrage (zero-investment) portfolios.

The value of this decomposition is that the returns on these portfolios are orthogonal (mutually),
i.e., the covariance between any pair is zero:
15
Capital Market Line
0 ) (
g m g s g gs
w w w w
,
since this is the difference between the covariance of
m
z
~
and
g
z
~
and the covariance of
g
z
~
and
g
z
~
.
0 ) (
m p g d g gd
w w w w
following the same logic as above.
0 ) ( ) (
m p g m p m d s sd
w w w w w w
The second term is zero as above and the first is also zero since the covariance of any portfolio
with w
m
(a min-var portfolio) is completely determined by that portfolios expected return and
w
m
and w
p
have the same expected return by construction.
Thus, from
d s g p
w w + +
and the mutual orthogonality of the terms we are able to
decompose the variance of the portfolio p as follows:
2 2 2 2
d s g p
+ + (all the covariances are zero)
Labels:
2
g
= unavoidable risk global min-var portfolio risk
2
s
= systematic risk added risk that provides added compensation
) (
g p
z z
2
d
= diversifiable risk due to being off the min-var frontier, added risk that
brings no added expected return.
Thus, only
2
g
and
2
s
contribute to expected return.
2
d
can be large, small, or zero without
affecting expected return. Draw a picture and see!
Alternatively:
d m p
w w +
Recall, w
m
is chosen so
m p
z z
. Let a be any min-var portfolio. Then
) (
z a ap z p
z z z z +
and,
) (
z a am z m
z z z z +
Since
m p
z z
it must be that Cov(z
a
, z
m
) = Cov(z
a
, z
p
).
Thus,
m p d
w w
must have zero covariance with any min-var portfolio (such as a). This is
the part of portfolio ps return that doesnt covary with the return on any min-var portfolio.
Expected returns are driven by covariances with min-var portfolios, since
d

does not contribute

to w
p
s covariance with w
a
, it does not contribute to expected return (you should remember this).
Equilibrium: The Capital Asset Pricing Model CAPM
16
To this point, this has been a standard minimization problem and the consequences of the
solution all math.
We cant use the results so far to price assets since you recall to get here we started by assuming
we knew the expected returns vector to find the min-var portfolios a bit circular.
Also, even if investors are not mean-variance optimizers, the min-var portfolios exist (as long as
mean and variance are well defined) and the absence of arbitrage provides the pricing results we
just saw. Thus, there is no economic content until we can identify one of the min-var portfolios.
This is really what the CAPM does. The mutual fund theorem says if all investors are mean-
variance optimizers we can, in equilibrium, identify a min-var portfolio.
Assume:
(1) Each investor chooses his/her portfolio to maximize a derived utility function
over z and
2
v( z ,
2
) where v
2
< 0 and v
1
> 0 and v is concave
(2) Investors have a common time horizon and homogenous beliefs about z and
(3) Each asset is infinitely divisible
(4) Unconstrained trading in the riskless asset
These assumptions are sufficient for all investors to hold mean-variance efficient portfolios.
Think about what each says.
Assume a riskless asset exists:
The maximization problem for each investor is:
) ), 1 ( ( w w R z w R v Max
w
+
FOC:
0 * ) ( 2 ) 1 )( (
2 1
+

w v R z v
w
v
So,
t
v
RA B v
R z
v
v
w w
) ( 2
) )( (
) 1 (
) ( 2
) (
*
2
1 1
2
1

Note that w* is proportional to the tangency portfolio and that it is chosen by each investor.
Thus, the aggregate demand for each risky asset is in proportion to its representation in w
t
.
The (positive or negative) remainder of each investors wealth is invested in R. Since, in
equilibrium, demand equals supply, it must be that the market portfolio of all risky assets w
m
is
proportional to w
t
. In other words, since all investors hold w
t
and R, the market portfolio w
m

the wealth weighted aggregate of all investors holdings must be some version of this. Thus w
m
is a min-var portfolio.
17
If the riskless asset is in zero net supply, w
t
= w
m
. If the riskless asset is in positive net supply,
then the market portfolio is located to the left of w
t
on the capital market line.
We can now write:
) ( 1 R z R z
m m

since the market portfolio w
m
is on the min-var frontier.
Further, we can note something about the holdings of investors:
If a riskless asset is available, we know that the mutual fund theorem (all investors effectively
hold only two assets) allows us to say that more risk averse investors hold less of w
t
or w
m
.
Indeed,
) 1 (
) ( 2
) (
*
1
2
1
R z
v
v
w

says just this: as
) ( 2
) (
2
1

v
v
is smaller as the individual investor is
more risk averse and this tells us how aggressively the investor holds w
t
.
(more risk averse (-v
2
) is bigger)
If there is no riskless asset, the same intuitions hold. Write:
) 1 1 ( ) , ( w w w z w v Max
w
+
FOCs:
0 1 * ) ( 2 ) (
2 1
+

w v z v
w
v
1 * 1

w
v

So,

1
) ( 2 ) ( 2
) (
*
1
2
1
2
1
v
z
v
v
w

=
g d
w
v
A
w
v
B v
) ( 2 ) ( 2
) (
2 2
1

Further, since 1 * 1 w , w* is a portfolio combination of w
d
and w
g
. Thus, all investors again
hold a portfolio combination of w
d
and w
g
or min-var portfolios. Aggregate demand is therefore
a portfolio combination of w
d
and w
g
and so w
m
must be a min-var portfolio itself.
Thus, we can write:
) ( 1
z m m z
z z z z +
or, for each asset:
) (
z m i z i
z z z z +
z
z is the expected return on a portfolio uncorrelated with the market portfolio and now this is the
Black CAPM.
When there is no riskless asset, we would like to use the same idea as we did before and say that
more risk averse investors (in the Arrow-Pratt sense) hold less of the market portfolio. Because
the holdings are in two risky assets, we cant in general say this. However,
18
1
) ( 2 ) ( 2
) (
*
1
2
1
2
1

v
z
v
v
w

says that more risk averse investors ((-v
2
) is bigger)
hold less of w
d
and so more of w
g
. We cannot, however, say things about the market portfolio,
individual assets, or other pairs of min-var portfolios.
(Note:
( )
A
B
v
v
A v
w
) ( 2
1
) ( 2
2
1
2
1 * 1

so
) )) ( (
2 ) ( 2
2

v as
v

Note: The CAPM has given us 2 measures of risk (1) the variance of a portfolio which
determines the efficiency of a given portfolio (macro risk if you will) and (2) beta which
measures the systematic risk of individual assets (micro level risk).
Note: Mean-variance analysis generates the separation results and the pricing results. The
equilibrium analysis simply identifies the market portfolio as being a minimum variance
portfolio.
Consistency of Mean-Variance Analysis and Expected Utility Maximization
(1) Quadratic Utility
We can write, without loss of generality,
2
) (
2
bz
z z u (with b>0) since utility is unique only
up to a positive affine transformation.
Expected Utility is then:
) , ( ) (
2
)] ( [
2 2 2
z v z
b
z z u E +
a function of mean return and variance of returns alone.
There are two drawbacks to quadratic utility:
(a) satiation u() is decreasing in return after some point; and
(b) increasing absolute risk aversion.
Neither, we believe, is consistent with reality.
(2) Multivariate Normal Returns for Assets
Portfolio combinations of normal random variables are normal and normal random variables are
completely characterized by their means and variances. Thus, each asset or portfolio is
characterized by z and
2
. Thus, for any u(z), E[u(z)] is characterized by z and
2
.
There are (at least) two drawbacks to this approach as well:
(a) limited liability; and
(b) derivatives.
Both imply that a (joint) normal distribution for returns on all the assets is not a reasonable
representation of reality.
19
The Three Moment Problem
Notation: We consider the 3
rd
central moment: skewness ] ) [(
3 3
z z E m
Co-skewness is defined as:
)] )( )( [(
k k j j i i ijk
z z z z z z E m
The skewness of a portfolio is given by:

N
i
N
j
ijk k j
N
k
i p
m w w w m
1 1 1
3
We consider that investors have derived utility functions: ) , , (
3 2
p p p
m z v - could come from a
cubic utility of returns where
3
p p
m and z
are liked and
2
p
is disliked.
To solve this problem, we could try to hold
p
z
and
2
p
fixed and max
3
p
m (analogously to the
CAPM approach), but this just gives a big mess.
Instead, start with an investor at his optimum
3 2
, ,
o o o
m z (o for optimal) then consider
perturbing him away from this optimum by having him sell some small amount (w) of his
optimal portfolio and buy this amount of individual asset i. The resulting portfolio p has:
i o p
z w z w z + ) 1 (
2 2 2 2 2
) 1 ( 2 ) 1 (
i io o p
w w w w + +
3 3 2 2 3 3 3
) 1 ( 3 ) 1 ( 3 ) 1 (
i oii ioo o p
m w m w w wm w m w m + + +
If we consider w
v

it should find a maximum at w = 0 by assumption.

) )( ( 3 ) )( ( 2 ) )( ( 0
3
3
2
2 1 o ioo o io o i
o w
m m v v z z v
w
v
+ +

) (
3
) (
2
3
1
3 2
1
2
o ioo o io o i
m m
v
v
v
v
z z
This must hold for any asset i
i
z
depends only on covariance and co-skewness of asset i
with the optimal portfolio (and some preference parameters which we will get rid of).
Note: Only
io

and
ioo
m
are important in the expected returns relation. As in the CAPM,
2
i
is
not important. Also,
iio
m
and
3
i
m are not important since they provide no tradeoffs at the
margin:
) ( 3
3
0
3
o ioo
w
o
m m
w
m

.
iio
m
and
3
i
m dont appear, so they dont affect the optimum.
ioo
m
contributes since skewness
ioo i o
m w m *
3
so it is asset is contribution to the skewness
of the optimal portfolio, just as
io i o
w *
2
implies asset is covariance with the optimal
portfolio determines asset is contribution to portfolio variance.
20
Also note
1
3
3
v
v
m
z
ioo
i

: If v
3
> 0 (so positive skewness is liked), this term is negative so
there is a substitution between z and
ioo
m
at the optimum.
If a riskless asset exists, the relation must hold for it:
3
1
3
2
1
2
3 2
o o o
m
v
v
v
v
z R + +
and so we can write:
2
3
1
3
2
1
2
3 ) ( 2
o
o
o
o
m
v
v R z
v
v

+

.
Then,
) (
3
) (
3
) (
3
1
3
2
2
3
1
3
2
2
o ioo o io
o
o
o
o io
o o i
m m
v
v m
v
v
R z z z +

+


=
) (
3
) (
3
1
3 o
i
o
i o
o
i o
m
v
v
R z R + +
where
2
o
io o
i

and
3
o
ioo o
i
m
m

If some investors optimal portfolio is the market portfolio (by happenstance) then the 1
st
two
terms duplicate the CAPM.
Finally, consider the asset with returns,
z
z
~
, that are uncorrelated with
o
z
~
and that has the
smallest variance of all such assets.
Here we need the further identification since not all zero-beta assets have the same
expected return as they did in the CAPM. Then,
) (
3
3
1
3 o
z o z
m
v
v
R z +
and
) (
) ( 3
3
1
3
o
z o
z
m
R z
v
v

We can then further develop the expected returns relation to:

) ( ) ( R z R z R z
z
o
z
o
i
o
i
o
o
i i

+ +

The intuition?
Any zero-beta asset will do the difference will be accounted for by different values of
z
z and
o
z
. Note, however, that we are still left with the need to identify some investors optimal
portfolio if we were to try to apply this pricing relation.
21