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# Eco 525: Financial Economics I

Lecture 05: Mean-Variance Analysis & Capital Asset Pricing Model (CAPM)
Prof. Markus K. Brunnermeier

16:14 Lecture 05

Slide 05-1

## Eco 525: Financial Economics I

Overview
Simple CAPM with quadratic utility functions
(derived from state-price beta model)

Mean-variance preferences
Portfolio Theory CAPM (intuition)

CAPM
Projections Pricing Kernel and Expectation Kernel
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-2

## Recall State-price Beta model

Recall: E[Rh] - Rf = h E[R*- Rf] where h := Cov[R*,Rh] / Var[R*]
very general but what is R* in reality?

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Slide 05-3

## Simple CAPM with Quadratic Expected Utility

1. All agents are identical
Expected utility U(x0, x1) = s s u(x0, xs) m= 1u / E[0u] Quadratic u(x0,x1)=v0(x0) - (x1- )2 1u = [-2(x1,1- ),, -2(xS,1- )] E[Rh] Rf = - Cov[m,Rh] / E[m] = -Rf Cov[1u, Rh] / E[0u] = -Rf Cov[-2(x1- ), Rh] / E[0u] = Rf 2Cov[x1,Rh] / E[0u] Also holds for market portfolio E[Rm] Rf = Rf 2Cov[x1,Rm]/E[0u]
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## Simple CAPM with Quadratic Expected Utility

2. Homogenous agents + Exchange economy x1 = agg. endowment and is perfectly correlated with Rm

## E[Rh]=Rf + h {E[Rm]-Rf} Market Security Line

N.B.: R*05 f (a+b1RMMean-Variance fAnalysis and CAPM (where b1<0)! =R )/(a+b1R ) in this case 16:14 Lecture
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-5

## Eco 525: Financial Economics I

Overview
Simple CAPM with quadratic utility functions
(derived from state-price beta model)

Mean-variance analysis
Portfolio Theory (Portfolio frontier, efficient frontier, ) CAPM (Intuition)

CAPM
Projections Pricing Kernel and Expectation Kernel
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-6

## Definition: Mean-Variance Dominance & Efficient Frontier

Asset (portfolio) A mean-variance dominates asset (portfolio) B if A B and A < or if A>Bwhile A B. Efficient frontier: loci of all non-dominated portfolios in the mean-standard deviation space. By definition, no (rational) mean-variance investor would choose to hold a portfolio not located on the efficient frontier.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-7

## Expected Portfolio Returns & Variance

Expected returns (linear) Variance
h p := E[rp ] = wj j , where each j = P
j j

hj

2 p := V ar[rp ]

= = =

w 0 V w = (w1 w2 )
2 (w1 1 + w2 21

2 1

21

12 2 2

2 w1 12 + w2 2 )

2 2 2 2 w1 1 + w2 2 + 2w1 w2 12 0

w1 w2 w1 w2

since 12 1 2 .

Slide 05-8

16:14 Lecture 05

## Illustration of 2 Asset Case

For certain weights: w1 and (1-w1) p = w1 E[r1]+ (1-w1) E[r2] 2p = w12 12 + (1-w1)2 22 + 2 w1(1-w1)1 2 1,2 (Specify 2p and one gets weights and ps) Special cases [w1 to obtain certain R]
1,2 = 1 w1 = (+/-p 2) / (1 2) 1,2 = -1 w1 = (+/- p + 2) / (1 + 2)
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-9

## Eco 525: Financial Economics I

For 1,2 = 1: p
p

= =

|w1 1 + (1 w1 )2 | w1 1 + (1 w1 )2

Hence, w1 =

p 2 1 2

E[r2]

p
E[r1]

p 2
Lower part with is irrelevant

## The Efficient Frontier: Two Perfectly Correlated Risky Assets

16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-10

## For 1,2 = -1:p

p

= =

|w1 1 (1 w1 )2 |

Hence, w1 =

w1 1 + (1 w1 )2

p +2 1 +2

E[r2]
2 1 +2 1

slope:

+ 11 2 2 +
E[r1]

2 1 1 +2 p

1 slope: 2 2 p 1 +

## Efficient Frontier: Two Perfectly Negative Correlated Risky Assets

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E[r2]

E[r1]

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Slide 05-12

## Eco 525: Financial Economics I

For 1 = 0

E[r2]

p
E[r1]

The Efficient Frontier: One Risky and One Risk Free Asset
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## Efficient Frontier with

n risky assets and one risk-free asset

## The Efficient Frontier: One Risk Free and n Risky Assets

16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-14

## Eco 525: Financial Economics I

Mean-Variance Preferences
U(p, p) with
U p

> 0,

U 2 p

<0

quadratic utility function (with portfolio return R) U(R) = a + b R + c R2 vNM: E[U(R)] = a + b E[R] + c E[R2] = a + b p + c p2 + c p2 = g(p, p) asset returns normally distributed R=j wj rj normal
if U(.) is CARA certainty equivalent = p - A/22p (Use moment generating function)
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## Optimal Portfolios of Two Investors with Different Risk Aversion

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## Eco 525: Financial Economics I

Portfolio theory: only analysis of demand
price/returns are taken as given composition of risky portfolio is same for all investors

## Equilibrium Demand = Supply (market portfolio) CAPM allows to derive

16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-17

## Eco 525: Financial Economics I

The CAPM with a risk-free bond The market portfolio is efficient since it is on the efficient frontier. All individual optimal portfolios are located on the half-line originating at point (0,rf). E[ R ] R The slope of Capital Market Line (CML): .
M f M

E[ R p ] = R f +

E[ RM ] R f

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Slide 05-18

## The Capital Market Line

CML

rM rf
j

M
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p
Slide 05-19

## Proof of the CAPM relationship [old traditional derivation]

Refer to previous figure. Consider a portfolio with a fraction 1 - of wealth invested in an arbitrary security j and a fraction in the market portfolio
p = M + (1 ) j
2 2 p = 2 M + (1 ) 2 2 + 2 (1 ) jM j

## As varies we trace a locus which

- passes through M (- and through j) - cannot cross the CML (why?) - hence must be tangent to the CML at M Tangency = dp = slope of the

## locus at M = r dp =1 = slope of CML = M M f

Mean-Variance Analysis and CAPM Slide 05-20

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## Eco 525: Financial Economics I

at =1 p = M

slope of dp = locus dp

M rf (M j )M |=1 = = 2 M jM M
jM 2 M

slope of =tangent!

E[rj ] = j = rf +
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(M rf )
Slide 05-21

## Do you see the connection to earlier state-price beta model? R* = RM

Mean-Variance Analysis and CAPM

E(r) SML E(ri)

E(rM)

M= 1

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Slide 05-22

## Eco 525: Financial Economics I

Overview
Simple CAPM with quadratic utility functions (derived from state-price beta model) Mean-variance preferences
Portfolio Theory CAPM (Intuition)

## CAPM (modern derivation)

Projections Pricing Kernel and Expectation Kernel

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Slide 05-23

## Eco 525: Financial Economics I

Projections
States s=1,,S with s >0 Probability inner product -norm (measure of length)

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Slide 05-24

y x

shrink axes

y x

## x and y are -orthogonal iff [x,y] = 0, I.e. E[xy]=0

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## Eco 525: Financial Economics I

Projections
Z space of all linear combinations of vectors z1, ,zn
Given a vector y RS solve

## [smallest distance between vector y and Z space]

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## Eco 525: Financial Economics I

Projections
y

yZ E[ zj]=0 for each j=1,,n (from FOC) z yZ is the (orthogonal) projection on Z y = yZ + , yZ Z, z Analysis and CAPM 16:14 Lecture 05 Mean-Variance

Slide 05-27

squeeze axis by

(1,1)

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Slide 05-28

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Slide 05-29

## Eco 525: Financial Economics I

Overview
Simple CAPM with quadratic utility functions
(derived from state-price beta model)

Mean-variance preferences
Portfolio Theory CAPM (Intuition)

## CAPM (modern derivation)

Projections Pricing Kernel and Expectation Kernel

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Slide 05-30

## New (LeRoy & Werner) Notation

Main changes (new versus old)
gross return: SDF: pricing kernel: Asset span: income/endowment: r=R =m kq = m* M = <X> wt = et

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Slide 05-31

## Eco 525: Financial Economics I

Pricing Kernel kq
M space of feasible payoffs. If no arbitrage and >>0 there exists SDF RS, >>0, such that q(z)=E( z). M SDF need not be in asset span. A pricing kernel is a kq M such that for each z M, q(z)=E(kq z).
(kq = m* in our old notation.)
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-32

## Pricing Kernel - Examples

Example 1:
S=3,s=1/3 for s=1,2,3, x1=(1,0,0), x2=(0,1,1), p=(1/3,2/3). Then k=(1,1,1) is the unique pricing kernel.

Example 2:
S=3,s=1/3 for s=1,2,3, x1=(1,0,0), x2=(0,1,0), p=(1/3,2/3). Then k=(1,2,0) is the unique pricing kernel.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-33

## Pricing Kernel Uniqueness

If a state price density exists, there exists a unique pricing kernel.
If dim(M) = m (markets are complete), there are exactly m equations and m unknowns If dim(M) m, (markets may be incomplete) For any state price density (=SDF) and any z M E[(-kq)z]=0 =(-kq)+kq kq is the projection'' of on M.
Complete markets , kq= (SDF=state price density)
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## Eco 525: Financial Economics I

Expectations Kernel ke
An expectations kernel is a vector ke M
Such that E(z)=E(ke z) for each z M.

Example If >>0, there exists a unique expectations kernel. Let e=(1,, 1) then for any z M E[(e-ke)z]=0 ke is the projection of e on M ke = e if bond can be replicated (e.g. if markets are complete)
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-35

S=3, s=1/3, for s=1,2,3, x1=(1,0,0), x2=(0,1,0). Then the unique ke=(1,1,0).

## Mean Variance Frontier

Definition 1: z M is in the mean variance frontier if there exists no z M such that E[z]= E[z], q(z')= q(z) and var[z] < var[z]. Definition 2: Let E the space generated by kq and ke. Decompose z=zE+, with zE E and E. Hence, E[]= E[ ke]=0, q()= E[ kq]=0 Cov[,zE]=E[ zE]=0, since E. var[z] = var[zE]+var[] (price of is zero, but positive variance) If z in mean variance frontier z E. Every z E is in mean variance frontier.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-36

## Eco 525: Financial Economics I

Frontier Returns
Frontier returns are the returns of frontier payoffs with non-zero prices.

## graphically: payoffs with price of p=1.

16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-37

## Eco 525: Financial Economics I

M = RS = R3
Mean-Variance Payoff Frontier

## kq Mean-Variance Return Frontier p=1-line = return-line (orthogonal to kq)

16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-38

(1,1,1)

## standard deviation expected return

kq

NB: graphical illustrated of expected returns and standard deviation changes if bond is not in payoff span.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-39

(1,1,1)

kq

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Slide 05-40

Frontier Returns

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Slide 05-41

## Minimum Variance Portfolio

Take FOC w.r.t. of

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Slide 05-42

## Mean-Variance Efficient Returns

Definition: A return is mean-variance efficient if there is no other return with same variance but greater expectation. Mean variance efficient returns are frontier returns with E[r] E[r0]. If risk-free asset can be replicated
Mean variance efficient returns correspond to 0. Pricing kernel (portfolio) is not mean-variance efficient, since

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Slide 05-43

## Zero-Covariance Frontier Returns

Take two frontier portfolios with returns and C The portfolios have zero co-variance if

## For all 0 exists =0 if risk-free bond can be replicated

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## Eco 525: Financial Economics I

Illustration of MVP
Expected return of MVP M = R2 and S=3

(1,1,1)

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Slide 05-45

## Eco 525: Financial Economics I

Illustration of ZC Portfolio
M = R2 and S=3 arbitrary portfolio p Recall:

(1,1,1)

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Slide 05-46

## Eco 525: Financial Economics I

Illustration of ZC Portfolio

(1,1,1)

arbitrary portfolio p

ZC of p

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Slide 05-47

## Eco 525: Financial Economics I

Frontier Returns (are on linear subspace). Hence Consider any asset with payoff xj
It can be decomposed in xj = xjE + j q(xj)=q(xjE) and E[xj]=E[xjE], since E. Let rjE be the return of xjE x Using above and assuming 0 and is ZC-portfolio of ,
Mean-Variance Analysis and CAPM Slide 05-48

Beta Pricing

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## Eco 525: Financial Economics I

Beta Pricing
Taking expectations and deriving covariance _

If risk-free asset can be replicated, beta-pricing equation simplifies to Problem: How to identify frontier returns
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-49

## Capital Asset Pricing Model

CAPM = market return is frontier return
Derive conditions under which market return is frontier return Two periods: 0,1, Endowment: individual wi1 at time 1, aggregate where the orthogonal projection of on M is. The market payoff: Assume q(m) 0, let rm=m / q(m), and assume that rm is not the minimum variance return.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-50

## Capital Asset Pricing Model

If rm0 is the frontier return that has zero covariance with rm then, for every security j, E[rj]=E[rm0] + j (E[rm]-E[rm0]), with j=cov[rj,rm] / var[rm]. If a risk free asset exists, equation becomes, E[rj]= rf + j (E[rm]- rf)
N.B. first equation always hold if there are only two assets.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-51

## Outdated material follows

Traditional derivation of CAPM is less elegant Not relevant for exams

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Slide 05-52

## Deriving the Frontier

n risky assets
Definition 6.1: A frontier portfolio is one which displays minimum variance among all feasible portfolios with the rp same E (~ ).

1 T min w Vw w 2

( ) ( )
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s.t. w T e = E w 1=1
T

N w E ( ~) = E ri i i=1 N w = 1 i i=1
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Slide 05-54

## Eco 525: Financial Economics I

Noting that eT wp = wTpe, using the first foc, the second foc can be written as

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Slide 05-55

## Hence, wp = V-1e + V-11 becomes

CE A 1 B AE 1 V e+ V 1 wp = D (vector) D (vector)
(scalar) (scalar)

wp = g + h

## (6.15) linear in expected return E! wp = g wp = g + h

Hence, g and g+h are portfolios on the frontier.

If E = 0, If E = 1,
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Slide 05-56

## Characterization of Frontier Portfolios

Proposition 6.1: The entire set of frontier portfolios can be generated by ("are convex combinations" of) g and g+h. Proposition 6.2. The portfolio frontier can be described as convex combinations of any two frontier portfolios, not just the frontier portfolios g and g+h. Proposition 6.3 : Any convex combination of frontier portfolios is also a frontier portfolio.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-57

## Characterization of Frontier Portfolios

r r r For any portfolio on the frontier, 2 (E[~p ]) = [g + hE (~p )] V [g + hE (~p )]
T

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Slide 05-58

## Characterization of Frontier Portfolios

(i) the expected return of the minimum variance portfolio is A/C; (ii) the variance of the minimum variance portfolio is given by 1/C; (iii) equation (6.17) is the equation of a parabola with vertex (1/C, A/C) in the expected return/variance space and of a hyperbola in the expected return/standard deviation space. See Figures 6.3 and 6.4.
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-59

Figure 6-3
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## The Set of Frontier Portfolios: Mean/Variance Space

Mean-Variance Analysis and CAPM Slide 05-60

Figure 6-4
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## The Set of Frontier Portfolios: Mean/SD Space

Mean-Variance Analysis and CAPM Slide 05-61

Figure 6-5
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## The Set of Frontier Portfolios: Short Selling Allowed

Mean-Variance Analysis and CAPM Slide 05-62

## Characterization of Efficient Portfolios

(No Risk-Free Assets)
Definition 6.2: Efficient portfolios are those frontier portfolios which are not mean-variance dominated. Lemma: Efficient portfolios are those frontier portfolios for which the expected return exceeds A/C, the expected return of the minimum variance portfolio.

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## Zero Covariance Portfolio

Zero-Cov Portfolio is useful for Zero-Beta CAPM Proposition 6.5: For any frontier portfolio p, except the minimum variance portfolio, there exists a unique frontier portfolio with which p has zero covariance. We will call this portfolio the "zero covariance portfolio relative to p", and denote its vector of portfolio weights by ZC(p ) . Proof: by construction.

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## Eco 525: Financial Economics I

collect all expected returns terms, add and subtract A2C/DC2 and note that the remaining term (1/C)[(BC/D)-(A2/D)]=1/C, since D=BC-A2
16:14 Lecture 05 Mean-Variance Analysis and CAPM Slide 05-65

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Slide 05-66

## Eco 525: Financial Economics I

Graphical Representation:

## line through p (Var[rp], E[rp]) MVP (1/C, A/C)

AND (use

C A 1 rp rp (~ ) = E(~ ) + D C C
2

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Slide 05-67

E(r)

A/C MVP

## ZC(p) E[r ( ZC(p)]

ZC (p) on frontier

(1/C)

Var ( r )

Figure 6-6

## The Set of Frontier Portfolios: Location of the Zero-Covariance Portfolio

Mean-Variance Analysis and CAPM Slide 05-68

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## Eco 525: Financial Economics I

Zero-Beta CAPM
(no risk-free asset)
(i) agents maximize expected utility with increasing and strictly concave utility of money functions and asset returns are multivariate normally distributed, or (ii) each agent chooses a portfolio with the objective of maximizing a derived utility function of the form U (e, 2 ), U1 > 0, U 2 < 0 , U concave. (iii) common time horizon, (iv) homogeneous beliefs about e and 2

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## Eco 525: Financial Economics I

All investors hold mean-variance efficient portfolios the market portfolio is convex combination of efficient portfolios is efficient. (q need not be on the frontier) (6.22) Cov[rp,rq] = E[rq]+ Cov[rp,rZC(p)] = E[rZC(p)] + =0 Cov[rp,rq] = {E[rq]-E[rZC(p)]} Var[rp] = {E[rp]-E[rZC(p)]} .

(6.28) (6.29)
Slide 05-70

## E (~j ) = E (~ ( M ) ) + Mj [E(~ ) E (~ ( M ) )] r rZC rM rZC

16:14 Lecture 05 Mean-Variance Analysis and CAPM

## Eco 525: Financial Economics I

Zero-Beta CAPM
mean variance framework (quadratic utility or normal returns) In equilibrium, market portfolio, which is a convex combination of individual portfolios E[rq] = E[rZC(M)]+ Mq[E[rM]-E[rZC(M)]] E[rj] = E[rZC(M)]+ Mj[E[rM]-E[rZC(M)]]
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## The Standard CAPM

(with risk-free asset)

FOC:
Multiplying by (erf 1)T and solving for yields

w p = V 1 (e rf 1)
nxn nx1 16:14 Lecture 05 nx1

rp E( ~ ) rf H
a number

(6.30)

Slide 05-72

## Holds for any frontier portfolio, in particular the market portfolio.

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