Crux of Research Papers (Not Rephrased)

Basics of Economics:
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Demand refers to how much (quantity) of a product or service
is desired by buyers. The quantity demanded is the amount of a product people are willing to buy
at a certain price; the relationship between price and quantity demanded is known as the demand
relationship. Supply represents how much the market can offer. The quantity supplied refers to
the amount of a certain good producers are willing to supply when receiving a certain price. The
correlation between price and how much of a good or service is supplied to the market is known
as the supply relationship. Price, therefore, is a reflection of supply and demand.
A. The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a
good, the less people will demand that good. In other words, the higher the price, the
lower the quantity demanded. The amount of a good that buyers purchase at a higher
price is less because as the price of a good goes up, so does the opportunity cost of
buying that good. As a result, people will naturally avoid buying a product that will force
them to forgo the consumption of something else they value more.
B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at
a certain price. But unlike the law of demand, the supply relationship shows an upward
slope. This means that the higher the price, the higher the quantity supplied. Producers
supply more at a higher price because selling a higher quantity at higher price increases
revenue.
Sharpe (1964)

Capital Assets Prices: A Theory of Market Equilibrium under Conditions of Risk

In equilibrium, capital asset prices have adjusted so that the investor, if he follows rational
procedures (primarily diversification), is able to attain any desired point along a capital market
line.
He may obtain a higher expected rate of return on his holdings only by incurring additional risk.
In effect, the market presents him with two prices: the price of time, or the pure interest rate
(shown by the intersection of the line with the horizontal axis) and the price of risk, the
additional expected return per unit of risk borne (the reciprocal of the slope of the line).
What is Expected Value?
Bernoulli (1937)
Expected values are computed by multiplying each possible gain by the number of ways in
which it can occur, and then dividing the sum of these products by the total number of
possible cases.
The determination of the value of an item must not be based on its price but rather on the utility
it yields. Price of the item is dependent only on the thing itself and is equal for everyone but
utility on the other hand is dependent on the particular state of the person making the estimate.
If the utility of each possible profit expectation is multiplied by the number of ways in which
it can occur, and we then divide the sum of these products by the total number of possible
cases, a mean utility [moral expectation] will be obtained, and the profit which corresponds to
this utility will equal the value of the risk in question.
Moreover, it sheds considerable light on the relationship between the price of an asset and the
various components of its overall risk. For these reasons it warrants consideration as a model of
the determination of capital asset prices.
The Investor's Preference Function
Assume that an individual views the outcome of any investment in probabilistic terms; that is, he
thinks of the possible results in terms of some probability distribution. In assessing the
desirability of a particular investment, however, he is willing to act on the basis of only two
parameters of this distribution-its expected value and standard deviation. This can be represented
by a total utility function of the form:
U = f (expected future wealth, standard deviation)
Investors are assumed to prefer a higher expected future wealth to a lower value (Rationality).
Moreover, they exhibit risk-aversion, choosing an investment offering a lower value of aw to one
with a greater level. These assumptions imply that indifference curves relating expected future
wealth and standard deviation will be upward-sloping.
Investment Opportunity Curve
The model of investor behavior considers the investors as choosing from the set of investment
opportunities which maximize his utility.
In order to derive conditions for equilibrium in the capital market we invoke two assumptions. First,
we assume a common pure rate of interest, with all investors able to borrow or lend funds on
equal terms. Second, we assume homogeneity of investor expectations.
Under these assumptions, given some set of capital asset prices, each investor will view his
alternatives in the same manner
THE PRICES OF CAPITAL ASSETS
We have argued that in equilibrium there will be a simple linear relationship between the
expected return and standard deviation of return for efficient combinations of risky assets. Thus
far nothing has been said about such a relationship for individual assets. Typically the expected
Return and standard deviation values associated with single assets will lie above the capital
market line, reflecting the inefficiency of undiversified holdings. Moreover, such points may be
scattered throughout the feasible region, with no consistent relation-ship between their expected
return and total risk. However, there will be a consistent relationship between their expected
returns and what might best be called systematic risk

Efficient Capital Markets: A Review of Theory and Empirical Work
Eugene F. Fama (1970)
A market in which prices always fully reflect available information is called efficient market





Portfolio Selection
Markowitz (1952)
This paper is concerned with the second stage. We first consider the rule that the investor does
(or should) maximize discounted expected, or anticipated, returns. This rule is rejected both as a
hypothesis to explain, and as a maximum to guide investment behavior. We next consider the
rule that the investor does (or should) consider expected return a desirable thing and variance of
return an undesirable thing.
One type of rule concerning choice of portfolio is that the investor does (or should) maximize the
discounted (or capitalized) value of future returns. Since the future is not known with certainty, it
must be "expected" or "anticipated' returns which we discount. Variations of this type of rule can
be suggested. Following Hicks, we could let "anticipated" returns include an allowance for risk.
Or, we could let the rate at which we capitalize the returns from particular securities vary with
risk.
The concepts "yield" and "risk" appear frequently in financial writings. Usually if the term
"yield" were replaced by "expected yield" or "expected return," and "risk" by "variance of
return," little change of apparent meaning would result.
Variance is a well-known measure of dispersion about the expected. If instead of variance the
investor was concerned with standard error, or with the coefficient of dispersion,

An Intertemporal Capital Asset Pricing Model
Robert C. Merton (1973)
Unlike a single-period maximizer who, by definition, does not consider events beyond the
present period, the intertemporal maximizer in selecting his portfolio takes into account the
relationship between current period returns and returns that will be available in the future.
The capital asset pricing model is a static (single-period) model although it is generally treated as
if it holds intertemporally.
It is assumed that the capital market is structured as follows.
ASSUMPTION1: All assets have limited liability.
ASSUMPTION 2: There are no transactions costs, taxes, or problems with in-divisibilities of
assets.
ASSUMPTION3: There are sufficient number of investors with comparable wealth levels so that
each investor believes that he can buy and sell as much of an asset as he wants at the market
price.
ASSUMPTION 4: The capital market is always in equilibrium (i.e., there is no trading at non-
equilibrium prices).
ASSUMPTION5: There exists an exchange market for borrowing and lending at the same rate of
interest.
ASSUMPTION6: Short-sales of all assets, with full use of the proceeds, is allowed.
ASSUMPTION 7: Trading in assets takes place continually in time.
ASSUMPTIONS1 to 6 are the standard assumptions of a perfect market, and their merits have
been discussed extensively in the literature. Although Assumption 7 is not standard, it almost
follows directly from Assumption 2. If there are no costs to transacting and assets can be
exchanged on any scale, then investors would prefer to be able to revise their portfolios at any
time (whether they actually do so or not). In reality, transactions costs and indivisibilities do
exist, and one reason given for finite trading-interval (discrete-time) models is to give implicit, if
not explicit, recognition to these costs.
An investor making a portfolio decision which is irrevocable ("frozen") for ten years, will choose
quite differently than the one who has the option (even at a cost) to revise his portfolio daily. The
essential issue is the market structure and not investors' tastes, and for well-developed capital
markets, the time interval between successive market openings is sufficiently small to make the
continuous-time assumption a good approximation.
Unlike a single-period maximizer who, by definition, does not consider events beyond the
present period, the intertemporal maximizer in selecting his portfolio takes into account the
relationship between current period returns and returns that will be available in the future. For
example, suppose that the current return on a particular asset is negatively correlated with
changes in yields ("capitalization" rates). Then, by holding this asset, the investor expects a
higher return on the asset if, ex post, yield opportunities next period are lower than were
expected. (CAPM is ex ant model based on probability or expectations rather actual
(ex-post)
ASSUMPTION 8: The vector set of stochastic processes describing the opportunity set and its
changes, is a time-homogeneous, Markov process.
ASSUMPTION 9: Only local changes in the state variables of the process are allowed.
ASSUMPTION 10: For each asset in the opportunity set at each point in time t, the expected rate
of return per unit time.