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Economics 434 Financial Markets Professor Burton University of Virginia Fall 2015 September 24, 2015 Definition of an Asset in Modern Portfolio Theory: As a probability distribution of returns (usually a normal distribution) Probability Density Function -- Returns -Instead of three (or any finite number of) states, there are an infinity of states possible with various probabilities of returns assigned September 18, 2014 Modern Portfolio Theory • Randomness • Construction of efficient (best) portfolios Harry Markowitz September 18, 2014 Harry Markowitz’s Conclusion Mean Maximizes Utility Standard Deviation September 18, 2014 James Tobin’s Result Mean Use of Leverage E Risk Free Asset Standard Deviation September 18, 2014 CAPM – two conclusions Bill Sharpe • M – the “efficient” basket • The pricing rule based upon “beta” September 18, 2014 Capital Market Line Mean M Rf What is M ? Answer: contains all “positively” priced assets, weighted by their “market” values. STDD September 18, 2014 Security Market Line i = Rf + i [M – Rf] Mean i M Rf Security Market Line Beta 1 September 18, 2014 Is CAPM Testable? • • • • Richard Roll – UCLA, 1982 Not a testable theory Can’t find market basket Without true market basket, can reach wrong conclusion • Is Beta dead? September 18, 2014 Fama-French • 1982 by Eugene Fama and Kenneth French • Research designed to test whether or not CAPM is true – Findings • Beta is largely irrelevant • Book/Market positively related to future performance • Size negatively related to future performance September 18, 2014 Performance Evaluation • • • • Absolute Return Doesn’t Tell You Much Need to Know What Risk Was Taken Beta is the normal measure of risk “Risk Adjusted” Performance is now the norm September 18, 2014 Roll’s Criticism Applies Here • Data might show superior performance • When performance is actually inferior • Data might show inferior performance • When performance is actually superior September 18, 2014 Two Things Keep Beta Going • The Limit Theorem • Ease of Computation September 18, 2014 September 24, 2015
