Hello, everyone. Thank you again for joining us. In this lecture, we're going to start talking about the capital asset pricing model, the CAPM. So, the CAPM is the main workhorse model in finance. It is important because it is the first theory that recognized that an asset risk Is not its total volatility but how it co-moves with other assets. The basic logic behind the capital asset pricing model is that there should be no premium for bearing risks that can be diversified away, right? So based on this logic, CAPM shows how risk and reward are related to each other. So, a little bit of history first. So, CAPM was developed in the 1960s by Jack Treynor, William Sharpe, John Lintner and Jan Mossin. They built on the principles of diversification and mean variance utility introduced earlier by Harry Markowitz. Now, years later, Sharpe and Markowitz shared the 1990 Nobel Prize in Economics with Merton Miller that year as well for their work on CAPM and portfolio choice. Now, unfortunately, Lintner and Mossin had already passed away by then, so they couldn't get the prize. And Treynor, never really published his manuscript so he never got the recognition he deserved. So, as I mentioned before, CAPM changed the way that the finance world thought about risk. Right? Until then, sort of practitioners thought about risk as being an asset source of volatility. All right? What CAPM show this, that the relevant measure of risk is not the total volatility in my solution but how an asset combos with the market portfolio. All right? Which we're going to call the beta of an asset. Now, I also have to tell you that, we know that CAPM does not work. It is firmly rejected by the data. I know, right? But, before you switch off and go away though, let me tell you. CAPM still remains as the main workhorse model of finance. We still teach it. We still advocate it. As in 5% of CFO's still employed. And it works pretty well or well enough for most applications. But most importantly, all right? It is a framework that conveys the intuition of how risk should be rewarded or how risk is rewarded. And therefore, provides a very good framework but how we should think about the risk premium and what drives the relationship behind risk and return. All right. So, mean variance analysis, right? Showed us how to select an optimal portfolio. Right? Given the inputs. Given expected returns, variances, correlations, and so on, all right? But it tells us nothing about what those expected returns should be or what prices should be. All right? Or what the equilibrium relationship between risk and return should be. So CAPM does exactly that. CAPM is an equilibrium model that characterizes the risk and return relationship of assets when investors are acting like mean variance optimizers. So, what do I mean by equilibrium? Well, equilibrium in this sense, means that nobody wants to do anything differently, right? In equilibrium, nobody would like to change anything. That's why it's an equilibrium, right? Everyone is optimized and prices are set and mark is clear, supply equals demand. So basically, CAPM asks the following question, all right? So, if everybody acted like mean variance optimizers, right? And if everybody in the economy holds an efficient portfolio, right? We know what that is now. All right? As we have seen before. What would the prices or expected returns have to look like so that market's clear, right? That's the basic question that the CAPM asks. Now, let's consider the following thought experiment, right? So, suppose all investors, everybody in the economy optimize, right? And choose their portfolio based on the prices that are sort of model came up with, right? But, we see that the IBM stock, right? Does not enter in to anybody's optimal portfolio choice, right? Basically, the weight on the IBM stock is zero, right? So what does that indicate? What would that indicate. Right? Well, if everybody is optimizing, right? And they're all giving it a zero weight to the IBM stock in their portfolios, right? It must be that investors think that IBM's price is too high. Or the expected return is too low for its measure of risks. So then, what would happen? Well, of course, what would happen for markets to clear, right? And for supply to equal demand, it would have to be that the IBM's price would have to come down. And if so that the investors would included in their portfolios, right? It would fall to such a level, such that the aggregated demand by all investors would equal to the total number of shares outstanding, okay? So, this is the sense in which CAPM is an equilibrium model, right? It tells us how assets should be priced in equilibrium when investors are main variance optimizers. So in this lecture, we introduced the capital asset pricing model, the main workers model in finance. And we also talked about what it means to be a equilibrium model. CAPM basically tells us the risk and return relationship in equilibrium.
