American Finance Association

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

Author(s): William F. Sharpe
Source: The Journal of Finance, Vol. 19, No. 3 (Sep., 1964), pp. 425-442
Published by: Blackwell Publishing for the American Finance Association
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T h e j o u r n a l o f FINANCE
VOL. XIX SEPT EMBER 1964 No . 3
CAPIT AL ASSET PRICES: A T HEORY OF MARKET
EQUILIBRIUM UNDER CONDIT IONS OF RISK*
WILLIAM F.
SHARPEt
I. INT RODUCT ION
ONE OF T HE PROBLEMS wh ich h a s pl a gu e d th o se a tte mptin g to pr e dict th e
be h a vio r o f ca pita l ma r ke ts is th e a bse n ce o f a bo dy o f po sitive micr o -
e co n o mic th e o r y de a l in g with co n ditio n s o f r isk. Al th o u gh ma n y u se f u l
in sigh ts ca n be o bta in e d f r o m th e tr a ditio n a l mo de l s o f in ve stme n t u n de r
co n ditio n s o f ce r ta in ty, th e pe r va sive in f l u e n ce o f r isk in f in a n cia l tr a n s-
a ctio n s h a s f o r ce d th o se wo r kin g in th is a r e a to a do pt mo de l s o f pr ice
be h a vio r wh ich a r e l ittl e mo r e th a n a sse r tio n s. A typica l cl a ssr o o m e x-
pl a n a tio n o f th e de te r min a tio n o f ca pita l a sse t pr ice s, f o r e xa mpl e ,
u su a l l y be gin s with a ca r e f u l a n d r e l a tive l y r igo r o u s de scr iptio n o f th e
pr o ce ss th r o u gh wh ich in dividu a l pr e f e r e n ce s a n d ph ysica l r e l a tio n sh ips
in te r a ct to de te r min e a n e qu il ibr iu m pu r e in te r e st r a te . T h is is ge n e r a l l y
f o l l o we d by th e a sse r tio n th a t so me h o w a ma r ke t r isk-pr e miu m is a l so
de te r min e d, with th e pr ice s o f a sse ts a dj u stin g a cco r din gl y to a cco u n t f o r
dif f e r e n ce s in th e ir r isk.
A u se f u l r e pr e se n ta tio n o f th e vie w o f th e ca pita l ma r ke t impl ie d in
su ch discu ssio n s is il l u str a te d in Figu r e 1. In e qu il ibr iu m, ca pita l a sse t
pr ice s h a ve a dj u ste d so th a t th e in ve sto r , if h e f o l l o ws r a tio n a l pr o ce du r e s
(pr ima r il y dive r sif ica tio n ), is a bl e to a tta in a n y de sir e d po in t a l o n g a
ca pita l ma r ke t l in e .' He ma y o bta in a h igh e r e xpe cte d r a te o f r e tu r n o n
h is h o l din gs o n l y by in cu r r in g a dditio n a l r isk. In e f f e ct, th e ma r ke t
pr e se n ts h im with two pr ice s: th e pr ice o f time , o r th e pu r e in te r e st r a te
(sh o wn by th e in te r se ctio n o f th e l in e with th e h o r izo n ta l a xis) a n d th e
pr ice o f r isk, th e a dditio n a l e xpe cte d r e tu r n pe r u n it o f r isk bo r n e (th e
r e cipr o ca l o f th e sl o pe o f th e l in e ).
*
A gr e a t ma n y pe o pl e pr o vide d co mme n ts o n e a r l y ve r sio n s o f th is
pa pe r wh ich l e d
to ma j o r impr o ve me n ts in th e e xpo sitio n . In a dditio n to th e r e f e r e e s, wh o we r e mo st
h e l pf u l , th e a u th o r wish e s to e xpr e ss h is a ppr e cia tio n to Dr . Ha r r y Ma r ko witz o f th e
RAND Co r po r a tio n , Pr o f e sso r Ja ck Hir sh l e if e r o f th e Un ive r sity o f Ca l if o r n ia a t Lo s
An ge l e s, a n d to Pr o f e sso r s Yo r a m Ba r ze l , Ge o r ge Br a bb, Br u ce Jo h n so n , Wa l te r Oi a n d
R. Ha n e y Sco tt o f th e Un ive r sity o f Wa sh in gto n .
t Asso cia te Pr o f e sso r o f Ope r a tio n s Re se a r ch , Un ive r sity o f Wa sh in gto n .
1.
Al th o u gh
so me discu ssio n s a r e a l so co n siste n t with a n o n -l in e a r (bu t mo n o to n ic) cu r ve .
425
426 T h e Jo u r n a l o f Fin a n ce
At pr e se n t th e r e is n o th e o r y de scr ibin g th e ma n n e r in wh ich th e pr ice
o f r isk r e su l ts f r o m th e ba sic in f l u e n ce s o f in ve sto r pr e f e r e n ce s, th e ph ysi-
ca l a ttr ibu te s o f ca pita l a sse ts, e tc. Mo r e o ve r , l a ckin g su ch a th e o r y, it is
dif f icu l t to give a n y r e a l me a n in g to th e r e l a tio n sh ip be twe e n th e pr ice
o f a sin gl e a sse t a n d its r isk. T h r o u gh dive r sif ica tio n , so me o f th e r isk
in h e r e n t in a n a sse t ca n be a vo ide d so th a t its to ta l r isk is o bvio u sl y n o t
th e r e l e va n t in f l u e n ce o n its pr ice ; u n f o r tu n a te l y l ittl e h a s be e n sa id
co n ce r n in g th e pa r ticu l a r r isk co mpo n e n t wh ich is r e l e va n t.
Risk
Ca pita l
Ma r ke t Lin e
0
Expe cte d Ra te
o f Re tu r n
Pu r e In te r e st'Ra te
FIGURE 1
In th e l a st te n ye a r s a n u mbe r o f e co n o mists h a ve de ve l o pe d
n o r ma tive
mo de l s de a l in g with a sse t ch o ice u n de r co n ditio n s o f r isk. Ma r ko witz,2
f o l l o win g Vo n Ne u ma n n a n d Mo r ge n ste r n , de ve l o pe d a n a n a l ysis
ba se d
o n th e e xpe cte d u til ity ma xim a n d pr o po se d
a ge n e r a l so l u tio n f o r th e
po r tf o l io se l e ctio n pr o bl e m. T o bin ' sh o we d th a t u n de r ce r ta in co n ditio n s
Ma r ko witz's mo de l impl ie s th a t th e pr o ce ss
o f in ve stme n t ch o ice ca n be
br o ke n do wn in to two ph a se s: f ir st,
th e ch o ice o f a u n iqu e o ptimu m
co mbin a tio n o f r isky a sse ts; a n d se co n d,
a se pa r a te ch o ice co n ce r n in g
th e
a l l o ca tio n o f f u n ds be twe e n su ch a co mbin a tio n a n d a sin gl e
r iskl e ss
2. Ha r r y M. Ma r ko witz, Po r tf o l io Se l e ctio n , Ef f icie n t Dive r sif ica tio n o f In ve stme n ts
(Ne w Yo r k: Jo h n Wil e y a n d So n s, In c., 1959). T h e ma j o r e l e me n ts o f th e th e o r y f ir st
a ppe a r e d in h is a r ticl e "Po r tf o l io Se l e ctio n ," T h e Jo u r n a l o f Fin a n ce , XII (Ma r ch 1952),
77-91.
3. Ja me s T o bin , "Liqu idity Pr e f e r e n ce a s Be h a vio r T o wa r ds Risk," T h e Re vie w o f
Eco n o mic Stu die s, XXV (Fe br u a r y, 1958), 65-86.
Ca pita l Asse t Pr ice s 427
a sse t. Re ce n tl y, Hicks4 h a s u se d a mo de l simil a r to th a t pr o po se d by
T o bin to de r ive co r r e spo n din g co n cl u sio n s a bo u t in dividu a l in ve sto r
be h a vio r , de a l in g so me wh a t mo r e e xpl icitl y with th e n a tu r e o f th e co n di-
tio n s u n de r wh ich th e pr o ce ss o f in ve stme n t ch o ice ca n be dich o to mize d.
An e ve n mo r e de ta il e d discu ssio n o f th is pr o ce ss, in cl u din g a r igo r o u s
pr o o f in th e co n te xt o f a ch o ice a mo n g l o tte r ie s h a s be e n pr e se n te d by
Go r do n a n d Ga n go l l i.5
Al th o u gh a l l th e a u th o r s cite d u se vir tu a l l y th e sa me mo de l o f in ve sto r
be h a vio r ,6 n o n e h a s ye t a tte mpte d to e xte n d it to co n str u ct a ma r ke t
e qu il ibr iu m th e o r y o f a sse t pr ice s u n de r co n ditio n s o f r isk. We wil l sh o w
th a t su ch a n e xte n sio n pr o vide s a th e o r y with impl ica tio n s co n siste n t with
th e a sse r tio n s o f tr a ditio n a l f in a n cia l th e o r y de scr ibe d a bo ve . Mo r e o ve r ,
it sh e ds co n side r a bl e l igh t o n th e r e l a tio n sh ip be twe e n th e pr ice o f a n
a sse t a n d th e va r io u s co mpo n e n ts o f its o ve r a l l r isk. Fo r th e se r e a so n s
it wa r r a n ts co n side r a tio n a s a mo de l o f th e de te r min a tio n o f ca pita l a sse t
pr ice s.
Pa r t II pr o vide s th e mo de l o f in dividu a l in ve sto r be h a vio r u n de r co n -
ditio n s o f r isk. In Pa r t III th e e qu il ibr iu m co n ditio n s f o r th e ca pita l
ma r ke t a r e co n side r e d a n d th e ca pita l ma r ke t l in e de r ive d. T h e impl ica -
tio n s f o r th e r e l a tio n sh ip be twe e n th e pr ice s o f in dividu a l ca pita l a sse ts
a n d th e va r io u s co mpo n e n ts o f r isk a r e de scr ibe d in Pa r t IV.
II. OPT IMAL INVEST MENT POLICY FOR T HE INDIVIDUAL
T h e In ve sto r 's Pr e f e r e n ce Fu n ctio n
Assu me th a t a n in dividu a l vie ws th e o u tco me o f a n y in ve stme n t in
pr o ba bil istic te r ms; th a t is, h e th in ks o f th e po ssibl e r e su l ts in te r ms o f
so me pr o ba bil ity distr ibu tio n . In a sse ssin g th e de sir a bil ity o f a pa r ticu l a r
in ve stme n t, h o we ve r , h e is wil l in g to a ct o n th e ba sis o f o n l y two pa r a -
4. Jo h n R. Hicks, "Liqu idity," T h e Eco n o mic Jo u r n a l , LXXII (De ce mbe r , 1962), 787-
802.
5. M. J. Go r do n a n d Ra me sh Ga n go l l i, "Ch o ice Amo n g a n d Sca l e o f Pl a y o n Lo tte r y
T ype Al te r n a tive s," Co l l e ge o f Bu sin e ss Admin istr a tio n , Un ive r sity o f Ro ch e ste r , 1962.
Fo r a n o th e r discu ssio n o f th is r e l a tio n sh ip se e W. F. Sh a r pe , "A Simpl if ie d Mo de l f o r
Po r tf o l io An a l ysis," Ma n a ge me n t Scie n ce , Vo l . 9, No . 2 (Ja n u a r y 1963), 277-293. A
r e l a te d discu ssio n ca n be f o u n d in F. Mo digl ia n i a n d M. H. Mil l e r , "T h e Co st o f Ca pita l ,
Co r po r a tio n Fin a n ce , a n d th e T h e o r y o f In ve stme n t," T h e Ame r ica n Eco n o mic Re vie w,
XLVIII (Ju n e 1958), 261-297.
6. Re ce n tl y Hir sh l e if e r h a s su gge ste d th a t th e me a n -va r ia n ce a ppr o a ch u se d in th e
a r ticl e s cite d is be st r e ga r de d a s a spe cia l ca se o f a mo r e ge n e r a l f o r mu l a tio n du e to
-Ar r o w. Se e Hir sh l e if e r 's "In ve stme n t De cisio n Un de r Un ce r ta in ty," Pa pe r s a n d Pr o ce e din gs
o f th e Se ve n ty-Sixth An n u a l Me e tin g o f th e Ame r ica n Eco n o mic Asso cia tio n , De c. 1963,
o r Ar r o w's "Le Ro l e de s Va l e u r s Bo u r sie r e s po u r l a Re pa r titio n l a Me il l e u r e de s Risqu e s,"
In te r n a tio n a l Co l l o qu iu m o n Eco n o me tr ics, 1952.
7. Af te r pr e pa r in g th is pa pe r th e a u th o r l e a r n e d th a t Mr . Ja ck L. T r e yn o r , o f Ar th u r
D. Littl e , In c., h a d in de pe n de n tl y de ve l o pe d a mo de l simil a r in ma n y r e spe cts to th e o n e
de scr ibe d h e r e . Un f o r tu n a te l y Mr . T r e yn o r 's e xce l l e n t wo r k o n th is su bj e ct is, a t pr e se n t,
u n pu bl ish e d.
428 T h e Jo u r n a l o f Fin a n ce
me te r s o f th is distr ibu tio n -its e xpe cte d va l u e a n d sta n da r d de via tio n .8
T h is ca n be r e pr e se n te d by a to ta l u til ity f u n ctio n o f th e f o r m:
U =
f (E,, a ,)
wh e r e Ew in dica te s e xpe cte d f u tu r e we a l th a n d cw th e pr e dicte d sta n da r d
de via tio n o f th e po ssibl e dive r ge n ce o f a ctu a l f u tu r e we a l th f r o m Ew.
In ve sto r s a r e a ssu me d to pr e f e r a h igh e r e xpe cte d f u tu r e we a l th to a
l o we r va l u e , ce te r is pa r ibu s (dU/dEw > 0). Mo r e o ve r , th e y e xh ibit
r isk-a ve r sio n , ch o o sin g a n in ve stme n t o f f e r in g a l o we r va l u e o f a w to
o n e with a gr e a te r l e ve l , give n th e l e ve l o f Ew (dU/do w < 0). T h e se a s-
su mptio n s impl y th a t in dif f e r e n ce cu r ve s r e l a tin g Ew a n d co wil l be
u pwa r d-sl o pin g.9
T o simpl if y th e a n a l ysis, we a ssu me th a t a n in ve sto r h a s de cide d to
co mmit a give n a mo u n t (WI) o f h is pr e se n t we a l th to in ve stme n t. Le ttin g
Wt be h is te r min a l we a l th a n d R th e r a te o f r e tu r n o n h is in ve stme n t:
R
Wt
Wi
WI
we h a ve
Wt R
WI +
Wi.
T h is r e l a tio n sh ip ma ke s it po ssibl e to e xpr e ss th e in ve sto r 's u til ity in
te r ms o f R, sin ce te r min a l we a l th is dir e ctl y r e l a te d to th e r a te o f r e tu r n :
U =
g(ER, OR)
.
Figu r e 2 su mma r ize s th e mo de l o f in ve sto r pr e f e r e n ce s in a f a mil y o f
in dif f e r e n ce cu r ve s; su cce ssive cu r ve s in dica te h igh e r l e ve l s o f u til ity a s
o n e mo ve s do wn a n d/o r to th e r igh t.10
8. Un de r ce r ta in co n ditio n s th e me a n -va r ia n ce a ppr o a ch ca n be sh o wn to l e a d to
u n sa tisf a cto r y pr e dictio n s o f be h a vio r . Ma r ko witz su gge sts th a t a mo de l ba se d o n th e
se mi-va r ia n ce (th e a ve r a ge o f th e squ a r e d de via tio n s be l o w th e me a n ) wo u l d be pr e f e r a bl e ;
in l igh t o f th e f o r mida bl e co mpu ta tio n a l pr o bl e ms, h o we ve r , h e ba se s h is a n a l ysis o n th e
va r ia n ce a n d sta n da r d de via tio n .
9. Wh il e o n l y th e se ch a r a cte r istics a r e r e qu ir e d f o r th e a n a l ysis, it is ge n e r a l l y a ssu me d
th a t th e cu r ve s h a ve th e pr o pe r ty o f dimin ish in g ma r gin a l r a te s o f su bstitu tio n be twe e n
EW
a n d
a w,
a s do th o se in o u r dia gr a ms.
10. Su ch in dif f e r e n ce cu r ve s ca n a l so be de r ive d by a ssu min g th a t th e in ve sto r wish e s
to ma ximize e xpe cte d u til ity a n d th a t h is to ta l u til ity ca n be r e pr e se n te d by a qu a dr a tic
f u n ctio n o f R with de cr e a sin g ma r gin a l u til ity. Bo th Ma r ko witz a n d T o bin pr e se n t su ch
a de r iva tio n . A simil a r a ppr o a ch is u se d by Do n a l d E. Fa r r a r in T h e In ve stme n t De cisio n
Un de r Un ce r ta in ty (Pr e n tice -Ha l l , 1962). Un f o r tu n a te l y Fa r r a r ma ke s a n e r r o r in h is
de r iva tio n ; h e a ppe a l s to th e Vo n -Ne u ma n n -Mo r ge n ste r n ca r din a l u til ity a xio ms to tr a n s-
f o r m a f u n ctio n o f th e f o r m:
E(U) =
a + bER
-
cER2 -CR2
in to o n e o f th e f o r m:
E
(U)
= k1 E
-k2a R2.
T h a t su ch a tr a n sf o r ma tio n is n o t co n siste n t with th e a xio ms ca n r e a dil y be se e n in th is
f o r m, sin ce th e f ir st e qu a tio n impl ie s n o n -l in e a r in dif f e r e n ce cu r ve s in th e
ER' a R2
pl a n e
wh il e th e se co n d impl ie s a l in e a r r e l a tio n sh ip. Obvio u sl y n o th r e e (dif f e r e n t) po in ts ca n
l ie o n bo th a l in e a n d a n o n -l in e a r cu r ve (with a mo n o to n ic de r iva tive ). T h u s th e two
f u n ctio n s mu st impl y dif f e r e n t o r de r in gs a mo n g a l te r n a tive ch o ice s in a t l e a st so me
in sta n ce .
Ca pita l Asse t Pr ice s 429
CYR
T h e ~. In e te n po r u iy u v
/h e
..
o r
// -7.....
T h se t o f in ve stme n t o ppo r tu n iti u r e s h to e wih msm sh su iiy
Eve r y in ve stme n t pl a n a va il a bl e to h im ma y be r e pr e se n te d by a po in t in
th e ER, OR pl a n e . If a l l su ch pl a n s in vo l ve so me r isk, th e a r e a co mpo se d
o f su ch po in ts wil l h a ve a n a ppe a r a n ce simil a r to th a t sh o wn in Figu r e 2.
T h e in ve sto r wil l ch o o se f r o m a mo n g a l l po ssibl e pl a n s th e o n e pl a cin g
h im o n th e in dif f e r e n ce cu r ve r e pr e se n tin g th e h igh e st l e ve l o f u til ity
(po in t F). T h e de cisio n ca n be ma de in two sta ge s: f ir st, f in d th e se t o f
e f f icie n t in ve stme n t pl a n s a n d, se co n d ch o o se o n e f r o m a mo n g th is se t.
A pl a n is sa id to be e f f icie n t if (a n d o n l y if ) th e r e is n o a l te r n a tive with
e ith e r (1) th e sa me ER a n d a l o we r CR, (2) th e sa me OR a n d a h igh e r EB
o r (3) a h igh e r ER a n d a l o we r CR. T h u s in ve stme n t Z is in e f f icie n t sin ce
in ve stme n ts B, C, a n d D (a mo n g o th e r s) do min a te it. T h e o n l y pl a n s
wh ich wo u l d be ch o se n mu st l ie a l o n g th e l o we r r igh t-h a n d bo u n da r y
(AFBDCX)- th e in ve stme n t o ppo r tu n ity cu r ve .
T o u n de r sta n d th e n a tu r e o f th is cu r ve , co n side r two in ve stme n t pl a n s
-A a n d B, e a ch in cl u din g o n e o r mo r e a sse ts. T h e ir pr e dicte d e xpe cte d
va l u e s a n d sta n da r d de via tio n s o f r a te o f r e tu r n a r e sh o wn in Figu r e 3.
430 T h e Jo u r n a l o f Fin a n ce
If th e pr o po r tio n a o f th e in dividu a l 's we a l th is pl a ce d in pl a n A a n d th e
r e ma in de r (1-a ) in
B,
th e e xpe cte d r a te o f r e tu r n o f th e co mbin a tio n wil l
l ie be twe e n th e e xpe cte d r e tu r n s o f th e two pl a n s:
ER= a ERa + (1 a ) ERb
T h e pr e dicte d sta n da r d de via tio n o f r e tu r n o f th e co mbin a tio n is:
RC
Va 2Ra
2
+ (1 a )2 Rb2 + 2r a b a (1
-
a ) CRa ORb
No te th a t th is r e l a tio n sh ip in cl u de s
r a b,
th e co r r e l a tio n co e f f icie n t be twe e n
th e pr e dicte d r a te s o f r e tu r n o f th e two in ve stme n t pl a n s. A va l u e o f +1
wo u l d in dica te a n in ve sto r 's be l ie f th a t th e r e is a pr e cise po sitive r e l a tio n -
sh ip be twe e n 'th e o u tco me s o f th e two in ve stme n ts. A ze r o va l u e wo u l d
in dica te a be l ie f th a t th e o u tco me s o f th e two in ve stme n ts a r e
co mpl e te l y
in de pe n de n t a n d -1 th a t th e in ve sto r f e e l s th a t th e r e is a
pr e cise in ve r se
r e l a tio n sh ip be twe e n th e m. In th e u su a l ca se r a b wil l h a ve a va l u e be twe e n
o a n d +1.
Figu r e 3 sh o ws th e po ssibl e va l u e s o f ERc a n d ORC o bta in a bl e with
dif f e r e n t co mbin a tio n s o f A a n d B u n de r two dif f e r e n t
a ssu mptio n s a bo u t
OR
a Rb -B
CRa -
I I
l I
I I
ERa
ERb
ER
FIGURE 3
Ca pita l Asse t Pr ice s 431
th e va l u e o f r a b. If th e two in ve stme n ts a r e pe r f e ctl y co r r e l a te d, th e
co mbin a tio n s wil l l ie a l o n g a str a igh t l in e be twe e n th e two po in ts, sin ce
in th is ca se bo th ERC a n d o Rc wil l be l in e a r l y r e l a te d to th e pr o po r tio n s
in ve ste d in th e two pl a n s.11 If th e y a r e l e ss th a n pe r f e ctl y po sitive l y co r -
r e l a te d, th e sta n da r d de via tio n o f a n y co mbin a tio n mu st be l e ss th a n th a t
o bta in e d with pe r f e ct co r r e l a tio n (sin ce r a b wil l be l e ss); th u s th e co mbi-
n a tio n s mu st l ie a l o n g a cu r ve be l o w th e l in e AB."2 AZB sh o ws su ch a
cu r ve f o r th e ca se o f co mpl e te in de pe n de n ce (r a b - 0); with n e ga tive
co r r e l a tio n th e l o cu s is e ve n mo r e U-sh a pe d.13
T h e ma n n e r in wh ich th e in ve stme n t o ppo r tu n ity cu r ve is f o r me d is
r e l a tive l y simpl e co n ce ptu a l l y, a l th o u gh e xa ct so l u tio n s a r e u su a l l y qu ite
dif f icu l t.14 On e f ir st tr a ce s cu r ve s in dica tin g ER, OR va l u e s a va il a bl e with
simpl e co mbin a tio n s o f in dividu a l a sse ts, th e n co n side r s co mbin a tio n s o f
co mbin a tio n s o f a sse ts. T h e l o we r r igh t-h a n d bo u n da r y mu st be e ith e r
l in e a r o r in cr e a sin g a t a n in cr e a sin g r a te (d2 CR/dE2R> 0). As su gge ste d
e a r l ie r , th e co mpl e xity o f th e r e l a tio n sh ip be twe e n th e ch a r a cte r istics o f
in dividu a l a sse ts a n d th e l o ca tio n o f th e in ve stme n t o ppo r tu n ity cu r ve
ma ke s it dif f icu l t to pr o vide a simpl e r u l e f o r a sse ssin g th e de sir a bil ity
o f in dividu a l a sse ts, sin ce th e e f f e ct o f a n a sse t o n a n in ve sto r 's o ve r -a l l
in ve stme n t o ppo r tu n ity cu r ve de pe n ds n o t o n l y o n its e xpe cte d r a te o f
r e tu r n (ERI) a n d r isk (CR1), bu t a l so o n its co r r e l a tio n s with th e o th e r
a va il a bl e o ppo r tu n itie s
(r ii, r I2 ...., r in ). Ho we ve r , su ch a r u l e is impl ie d
by th e e qu il ibr iu m co n ditio n s f o r th e mo de l , a s we wil l sh o w in pa r t IV.
T h e Pu r e Ra te o f In te r e st
We h a ve n o t ye t de a l t with r iskl e ss a sse ts. Le t P be su ch a n a sse t; its
r isk is ze r o (o Rp = 0) a n d its e xpe cte d r a te o f r e tu r n , ERR, is e qu a l (by
de f in itio n ) to th e pu r e in te r e st r a te . If a n in ve sto r pl a ce s a o f h is we a l th
11. ERC = a ERa + (1 -a ) ERb = ERb + (ERa ERb)
ORC
=
V/a 2Ra 2
+ (1- a )2
cvRb2
+
2r a b a (1
-
a )
r Ra a Rb
bu ta b 1,
th e r e f o r e th e
e xpr e ssio n
u n de r th e
squ a r e
r o o t
sign
ca n be f a cto r e d:
YRc = \/[a a Ra
+ (1 GO) cRb]2
-
a
YRa + (1
-
a )
a Rb
- 0Rb + (OYRa
-
YRb)
a
12. T h is cu r va tu r e
is,
in
e sse n ce ,
th e r a tio n a l e f o r dive r sif ica tio n .
13. Wh e n r a b = 0, th e sl o pe o f th e cu r ve a t po in t A is
-
, a t po in t B it is
ERb
-
ERa
YRb
. Wh e n r a b =-1, th e cu r ve de ge n e r a te s to two
str a igh t
l in e s to a
po in t
ERb-
ERa
o n th e h o r izo n ta l a xis.
14. Ma r ko witz h a s sh o wn th a t th is is a pr o bl e m in pa r a me tr ic qu a dr a tic pr o gr a mmin g.
An e f f icie n t so l u tio n te ch n iqu e is de scr ibe d in h is a r ticl e , "T h e Optimiza tio n
o f a
Qu a dr a tic
Fu n ctio n Su bj e ct to Lin e a r Co n str a in ts,"
Na va l Re se a r ch Lo gistics Qu a r te r l y,
Vo l . 3
(Ma r ch a n d Ju n e , 1956), 111-133. A so l u tio n me th o d f o r a
spe cia l ca se is
give n
in th e
a u th o r 's "A Simpl if ie d Mo de l f o r Po r tf o l io An a l ysis," o p.
cit.
432 T h e Jo u r n a l o f Fin a n ce
in P a n d th e r e ma in de r in so me r isky a sse t A, h e wo u l d o bta in a n
e xpe cte d
r a te o f r e tu r n :
ERC= a ERP + (1
-
a ) ER1a
T h e sta n da r d de via tio n o f su ch a co mbin a tio n wo u l d be :
0Rc
-
V\a 202Rp
+
( -a )2a u a 2
+ 2r pa a (1-a )
(}Rpl Ra
bu t sin ce
ORp
=
0,
th is r e du ce s to :
Cr R
=
(1 a ) (Ra .
T h is impl ie s th a t a l l co mbin a tio n s in vo l vin g a n y r isky
a sse t o r co mbi-
n a tio n o f a sse ts pl u s th e r iskl e ss a sse t mu st h a ve va l u e s o f ERC a n d OCR
wh ich l ie a l o n g a str a igh t l in e be twe e n th e
po in ts r e pr e se n tin g
th e two
co mpo n e n ts. T h u s in Figu r e 4 a l l co mbin a tio n s o f ER a n d OR l yin g a l o n g
Oa R
P'
'v
FIGURiE 4
th e l in e PA a r e a tta in a bl e 'if so me
mo n e y
is l o a n e d a t th e
pu r e
r a te a n d
so me
pBl a ce d
in A.
Simil a r l y, by l e n din g
a t th e
pu r e
r a te a n d
in ve stin g
in
B,
co mbin a tio n s
a l o n g
PB ca n be a tta in e d. Of a l l su ch
po ssibil itie s,
h o w-
e ve r ,
o n e wil l do min a te : th a t in ve stme n t
pl a n l yin g
a t th e
po in t
o f th e
o r igin a l
in ve stme n t
o ppr o r tu n ity
cu r ve wh e r e a
r a y
f r o m
po in t
P is
ta n ge n t
to th e cu r ve . In
Figu r e
4 a l l in ve stme n ts
l yin g a l o n g
th e
o r igin a l
cu r ve
Ca pita l Asse t Pr ice s 433
f r o m X to
cP
a r e do min a te d by so me co mbin a tio n o f in ve stme n t in
4
a n d
l e n din g a t th e pu r e in te r e st r a te .
Co n side r n e xt th e po ssibil ity o f bo r r o win g. If th e in ve sto r ca n bo r r o w
a t th e pu r e r a te o f in te r e st, th is is e qu iva l e n t to disin ve stin g in P. T h e
e f f e ct o f bo r r o win g to pu r ch a se mo r e o f a n y give n in ve stme n t th a n is
po ssibl e with th e give n a mo u n t o f we a l th ca n be f o u n d simpl y by l e ttin g
a ta ke o n n e ga tive va l u e s in th e e qu a tio n s de r ive d f o r th e ca se o f l e n din g.
T h is wil l o bvio u sl y give po in ts l yin g a l o n g th e e xte n sio n o f l in e PA if
bo r r o win g is u se d to pu r ch a se mo r e o f A; po in ts l yin g a l o n g th e e xte n sio n
o f PB if th e f u n ds a r e u se d to pu r ch a se B, e tc.
As in th e ca se o f l e n din g, h o we ve r , o n e in ve stme n t pl a n wil l do min a te
a l l o th e r s wh e n bo r r o win g is po ssibl e . Wh e n th e r a te a t wh ich f u n ds ca n
be bo r r o we d e qu a l s th e l e n din g r a te , th is pl a n wil l be th e sa me o n e wh ich
is do min a n t if l e n din g is to ta ke pl a ce . Un de r th e se co n ditio n s, th e in ve st-
me n t o ppo r tu n ity cu r ve be co me s a l in e
(POZ
in Figu r e 4). Mo r e o ve r ,
if th e o r igin a l in ve stme n t o ppo r tu n ity cu r ve is n o t l in e a r a t po in t c, th e
pr o ce ss o f in ve stme n t ch o ice ca n be dich o to mize d a s f o l l o ws: f ir st se l e ct
th e (u n iqu e ) o ptimu m co mbin a tio n o f r isky a sse ts (po in t c), a n d se co n d
bo r r o w o r l e n d to o bta in th e pa r ticu l a r po in t o n PZ a t wh ich a n in dif f e r -
e n ce cu r ve is ta n ge n t to th e l in e .'5
Be f o r e pr o ce e din g with th e a n a l ysis, it ma y be u se f u l to co n side r a l te r -
n a tive a ssu mptio n s u n de r wh ich o n l y a co mbin a tio n o f a sse ts l yin g a t th e
po in t o f ta n ge n cy be twe e n th e o r igin a l in ve stme n t o ppo r tu n ity cu r ve a n d
a r a y f r o m P ca n be e f f icie n t. Eve n if bo r r o win g is impo ssibl e , th e in ve sto r
wil l ch o o se 4
(a n d l e n din g) if h is r isk-a ve r sio n l e a ds h im to a po in t
be l o w 4) o n th e l in e
Pq).
Sin ce a l a r ge n u mbe r o f in ve sto r s ch o o se to pl a ce
so me o f th e ir f u n ds in r e l a tive l y r isk-f r e e in ve stme n ts, th is is n o t a n u n -
l ike l y po ssibil ity. Al te r n a tive l y, if bo r r o win g is po ssibl e bu t o n l y u p to
so me l imit, th e ch o ice o f 4) wo u l d be ma de by a l l bu t th o se in ve sto r s
wil l in g to u n de r ta ke co n side r a bl e r isk. T h e se a l te r n a tive pa th s l e a d to th e
ma in co n cl u sio n , th u s ma kin g th e a ssu mptio n o f bo r r o win g o r l e n din g
a t th e pu r e in te r e st r a te l e ss o n e r o u s th a n it migh t in itia l l y a ppe a r to be .
III. EQUILIBRIUM IN T HE CAPIT AL MARKET
In o r de r to de r ive co n ditio n s f o r e qu il ibr iu m in th e ca pita l ma r ke t we
in vo ke two a ssu mptio n s. Fir st, we a ssu me a co mmo n pu r e r a te o f
in te r e st,
with a l l in ve sto r s a bl e to bo r r o w o r l e n d f u n ds o n
e qu a l te r ms.
Se co n d,
we a ssu me h o mo ge n e ity o f in ve sto r e xpe cta tio n s:16 in ve sto r s a r e a ssu me d
15. T h is pr o o f wa s f ir st pr e se n te d by T o bin f o r th e ca se in wh ich th e pu r e r a te o f
in te r e st is ze r o (ca sh ). Hicks co n side r s th e l e n din g situ a tio n u n de r co mpa r a bl e co n ditio n s
bu t do e s n o t a l l o w bo r r o win g. Bo th a u th o r s pr e se n t th e ir a n a l ysis u sin g ma ximiza tio n
su bj e ct to co n str a in ts e xpr e sse d a s e qu a l itie s. Hicks' a n a l ysis a ssu me s in de pe n de n ce a n d
th u s in su r e s th a t th e so l u tio n wil l in cl u de n o n e ga tive h o l din gs o f
r isky a sse ts; T o bin 's
co ve r s th e ge n e r a l ca se , th u s h is so l u tio n wo u l d
ge n e r a l l y
in cl u de
n e ga tive h o l din gs o f
so me a sse ts. T h e discu ssio n in th is pa pe r is ba se d o n Ma r ko witz'
f o r mu l a tio n , wh ich
in cl u de s n o n -n e ga tivity co n str a in ts o n th e h o l din gs o f a l l a sse ts.
16. A te r m su gge ste d by o n e o f th e r e f e r e e s.
434 T h e Jo u r n a l o f Fin a n ce
to a gr e e o n th e pr o spe cts o f va r io u s in ve stme n ts-th e e xpe cte d va l u e s,
sta n da r d de via tio n s a n d co r r e l a tio n co e f f icie n ts de scr ibe d in Pa r t II.
Ne e dl e ss to sa y, th e se a r e h igh l y r e str ictive a n d u n do u bte dl y u n r e a l istic
a ssu mptio n s.
Ho we ve r ,
sin ce th e pr o pe r te st o f a th e o r y is n o t th e r e a l ism
o f its a ssu mptio n s bu t th e a cce pta bil ity o f its
impl ica tio n s,
a n d sin ce th e se
a ssu mptio n s impl y e qu il ibr iu m co n ditio n s wh ich f o r m a ma j o r pa r t
o f cl a ssica l f in a n cia l do ctr in e , it is f a r f r o m cl e a r th a t th is f o r mu l a tio n
sh o u l d be r e j e cte d-e spe cia l l y in vie w o f th e de a r th o f a l te r n a tive mo de l s
l e a din g to simil a r r e su l ts.
Un de r th e se a ssu mptio n s,
give n
so me se t o f ca pita l a sse t pr ice s, e a ch
in ve sto r wil l vie w h is a l te r n a tive s in th e sa me ma n n e r . Fo r o n e se t o f
pr ice s th e a l te r n a tive s migh t a ppe a r a s sh o wn in Figu r e 5. In th is situ a -
a R
Cl
C2
-
-C3
C1/
/
B ~~
B~2
1/ /
A3
P
ER
FIGURE 5
tio n a n in ve sto r with th e pr e f e r e n ce s
in dica te d by
in dif f e r e n ce cu r ve s A1
th r o u gh A4 wo u l d se e k to l e n d so me o f h is f u n ds a t th e pu r e in te r e st r a te
a n d to in ve st th e r e ma in de r in th e co mbin a tio n o f a sse ts sh o wn by po in t
4,0
sin ce th is wo u l d give h im th e pr e f e r r e d o ve r -a l l po sitio n A*. An in ve sto r
with th e pr e f e r e n ce s in dica te d by cu r ve s B1 th r o u gh B4 wo u l d se e k to in -
ve st a l l h is f u n ds in co mbin a tio n 4, wh il e a n in ve sto r with in dif f e r e n ce
cu r ve s C1 th r o u gh C4 wo u l d in ve st a l l h is f u n ds pl u s
a dditio n a l (bo r r o we d)
Ca pita l Asse t Pr ice s 435
f u n ds in co mbin a tio n 4 in o r de r to r e a ch h is pr e f e r r e d po sitio n (C*). In
a n y e ve n t, a l l wo u l d a tte mpt to pu r ch a se o n l y th o se r isky a sse ts wh ich
e n te r co mbin a tio n b.
T h e a tte mpts by in ve sto r s to pu r ch a se th e a sse ts in co mbin a tio n 4
a n d
th e ir l a ck o f in te r e st in h o l din g a sse ts n o t in co mbin a tio n ' wo u l d, o f
co u r se , l e a d to a r e visio n o f pr ice s. T h e pr ice s o f a sse ts in 4 wil l r ise a n d,
sin ce a n a sse t's e xpe cte d r e tu r n r e l a te s f u tu r e in co me to pr e se n t pr ice ,
th e ir e xpe cte d r e tu r n s wil l f a l l . T h is wil l r e du ce th e a ttr a ctive n e ss o f co m-
bin a tio n s wh ich in cl u de su ch a sse ts; th u s po in t
'
(a mo n g o th e r s) wil l
mo ve to th e l e f t o f its in itia l po sitio n .'7 On th e o th e r h a n d, th e pr ice s o f
a sse ts n o t in
'
wil l f a l l , ca u sin g a n in cr e a se in th e ir e xpe cte d r e tu r n s a n d
a r igh twa r d mo ve me n t o f po in ts r e pr e se n tin g co mbin a tio n s wh ich in cl u de
th e m. Su ch pr ice ch a n ge s wil l l e a d to a r e visio n o f in ve sto r s' a ctio n s; so me
n e w co mbin a tio n o r co mbin a tio n s wil l be co me a ttr a ctive , l e a din g to dif -
f e r e n t de ma n ds a n d th u s to f u r th e r r e visio n s in pr ice s. As th e pr o ce ss co n -
tin u e s, th e in ve stme n t o ppo r tu n ity cu r ve wil l te n d to be co me mo r e l in e a r ,
with po in ts su ch a s
'
mo vin g to th e l e f t a n d f o r me r l y in e f f icie n t po in ts
(su ch a s F a n d G) mo vin g to th e r igh t.
Ca pita l a sse t pr ice s mu st, o f co u r se , co n tin u e to ch a n ge u n til a se t o f
pr ice s is a tta in e d f o r wh ich e ve r y a sse t e n te r s a t l e a st o n e co mbin a tio n
l yin g o n th e ca pita l ma r ke t l in e . Figu r e 6 il l u str a te s su ch a n e qu il ibr iu m
co n ditio n .'8 Al l po ssibil itie s in th e sh a de d a r e a ca n be a tta in e d with co m-
bin a tio n s o f r isky a sse ts, wh il e po in ts l yin g a l o n g th e l in e PZ ca n be a t-
ta in e d by bo r r o win g o r l e n din g a t th e pu r e r a te pl u s a n in ve stme n t in
so me co mbin a tio n o f r isky a sse ts. Ce r ta in po ssibil itie s (th o se l yin g a l o n g
PZ f r o m po in t A to po in t B) ca n be o bta in e d in e ith e r ma n n e r . Fo r e x-
a mpl e , th e ER, a R va l u e s sh o wn by po in t A ca n be o bta in e d so l e l y by
so me
co mbin a tio n o f r isky a sse ts; a l te r n a tive l y, th e po in t ca n be r e a ch e d
by a
co mbin a tio n o f l e n din g a n d in ve stin g in co mbin a tio n C o f
r isky a sse ts.
It is impo r ta n t to r e co gn ize th a t in th e situ a tio n sh o wn in
Figu r e 6
ma n y a l te r n a tive co mbin a tio n s o f r isky a sse ts a r e e f f icie n t
(i.e .,
l ie
a l o n g
l in e PZ), a n d th u s th e th e o r y do e s n o t
impl y
th a t a l l in ve sto r s wil l h o l d
th e sa me co mbin a tio n ."9 On th e o th e r
h a n d,
a l l su ch co mbin a tio n s mu st
be pe r f e ctl y (po sitive l y) co r r e l a te d,
sin ce
th e y
l ie
a l o n g
a l in e a r bo r de r o f
17. If in ve sto r s co n side r th e va r ia bil ity o f f u tu r e do l l a r r e tu r n s u n r e l a te d to pr e se n t
pr ice , bo th ER a n d cR wil l f a l l ; u n de r th e se co n ditio n s th e po in t r e pr e se n tin g a n a sse t
wo u l d mo ve a l o n g a r a y th r o u gh th e o r igin a s its pr ice ch a n ge s.
18. T h e a r e a in Figu r e 6 r e pr e se n tin g ER' a R va l u e s a tta in e d with o n l y r isky a sse ts
h a s be e n dr a wn a t so me dista n ce f r o m th e h o r izo n ta l a xis f o r e mph a sis. It is l ike l y th a t
a mo r e a ccu r a te r e pr e se n ta tio n wo u l d pl a ce it ve r y cl o se to th e a xis.
19. T h is sta te me n t co n tr a dicts T o bin 's co n cl u sio n th a t th e r e wil l be a u n iqu e o ptima l
co mbin a tio n o f r isky a sse ts. T o bin 's pr o o f o f a u n iqu e o ptimu m ca n be sh o wn to be
in co r r e ct f o r th e ca se o f pe r f e ct co r r e l a tio n o f e f f icie n t r isky in ve stme n t pl a n s if th e
l in e co n n e ctin g th e ir ER, a R po in ts wo u l d pa ss th r o u gh po in t P. In th e gr a ph o n pa ge 83
o f th is a r ticl e (o p. cit.) th e co n sta n t-r isk l o cu s wo u l d, in th is ca se , de ge n e r a te f r o m a
f a mil y o f e l l ipse s in to o n e o f str a igh t l in e s pa r a l l e l to th e co n sta n t-r e tu r n l o ci, th u s givin g
mu l tipl e o ptima .
436 T h e Jo u r n a l o f Fin a n ce
th e ER, o R r e gio n .20 T h is pr o vide s a ke y to th e r e l a tio n sh ip be twe e n th e
pr ice s o f ca pita l a sse ts a n d dif f e r e n t type s o f r isk.
a Rl
B
p ER
FIGURE 6
IV. T HE PRICES OF CAPIT AL ASSET S
We h a ve a r gu e d th a t in e qu il ibr iu m th e r e wil l be a simpl e l in e a r r e l a -
tio n sh ip be twe e n th e e xpe cte d r e tu r n a n d sta n da r d de via tio n o f r e tu r n f o r
e f f icie n t co mbin a tio n s o f r isky a sse ts. T h u s f a r n o th in g h a s be e n sa id
a bo u t su ch a r e l a tio n sh ip f o r in dividu a l a sse ts. T ypica l l y th e ER, OR va l u e s
a sso cia te d with sin gl e a sse ts wil l l ie a bo ve th e ca pita l ma r ke t l in e , r e f l e ct-
in g th e in e f f icie n cy o f u n dive r sif ie d h o l din gs. Mo r e o ve r , su ch po in ts ma y
be sca tte r e d th r o u gh o u t th e f e a sibl e r e gio n , with n o co n siste n t r e l a tio n -
sh ip be twe e n th e ir e xpe cte d r e tu r n a n d to ta l r isk (OR). Ho we ve r , th e r e
wil l be a co n siste n t r e l a tio n sh ip be twe e n th e ir e xpe cte d r e tu r n s a n d wh a t
migh t be st be ca l l e d syste ma tic r isk, a s we wil l n o w sh o w.
Figu r e 7 il l u str a te s th e typica l r e l a tio n sh ip be twe e n a sin gl e ca pita l
20. ER, 0R va l u e s give n by co mbin a tio n s o f a n y two co mbin a tio n s mu st l ie with in
th e r e gio n a n d ca n n o t pl o t a bo ve a str a igh t l in e j o in in g th e po in ts. In th is ca se th e y ca n n o t
pl o t be l o w su ch a str a igh t l in e . Bu t sin ce o n l y in th e ca se o f pe r f e ct co r r e l a tio n wil l th e y
pl o t a l o n g a str a igh t l in e , th e two co mbin a tio n s mu st be pe r f e ctl y co r r e l a te d. As sh o wn
in Pa r t IV, th is do e s n o t n e ce ssa r il y impl y th a t th e in dividu a l se cu r itie s th e y co n ta in
a r e pe r f e ctl y co r r e l a te d.
Ca pita l Asse t Pr ice s 437
a sse t (po in t i) a n d a n e f f icie n t co mbin a tio n o f a sse ts (po in t g) o f wh ich
it is a pa r t. T h e cu r ve igg' in dica te s a l l
ERJ,
o R va l u e s wh ich ca n be o bta in e d
with f e a sibl e co mbin a tio n s o f a sse t i a n d co mbin a tio n g. As be f o r e , we
de n o te su ch a co mbin a tio n in te r ms o f a pr o po r tio n
a .
o f a sse t i a n d
(1 a ) o f co mbin a tio n g. A va l u e o f a 1 wo u l d in dica te pu r e in ve st-
?R _
P
ER
FiGu RE 7
me n t in a sse t i wh il e a = 0 wo u l d impl y in ve stme n t in co mbin a tio n g.
No te , h o we ve r , th a t a = .5 impl ie s
a to ta l in ve stme n t o f mo r e th a n h a l f
th e f u n ds in a sse t i, sin ce h a l f wo u l d be in ve ste d in i itse l f a n d th e o th e r
h a l f u se d to pu r ch a se co mbin a tio n g, wh ich a l so in cl u de s so me o f a sse t i.
T h is me a n s th a t a co mbin a tio n in wh ich a sse t i do e s n o t a ppe a r a t a l l mu st
be r e pr e se n te d by so me n e ga tive va l u e o f a . Po in t g' in dica te s su ch a
co mbin a tio n .
In Figu r e 7 th e cu r ve igg' h a s be e n dr a wn ta n ge n t to th e ca pita l ma r ke t
l in e (PZ) a t po in t g. T h is is n o a ccide n t. Al l su ch cu r ve s mu st be ta n ge n t
to th e ca pita l ma r ke t l in e in e qu il ibr iu m, sin ce (1) th e y mu st to u ch it a t
th e po in t r e pr e se n tin g th e e f f icie n t co mbin a tio n a n d (2) th e y a r e co n -
tin u o u s a t th a t po in t.2' Un de r th e se co n ditio n s a l a ck o f ta n ge n cy wo u l d
21. On l y if r ig
= -1 wil l th e cu r ve be disco n tin u o u s o ve r th e r a n ge in qu e stio n .
438 T h e Jo u r n a l o f Fin a n ce
impl y th a t th e cu r ve in te r se cts PZ. Bu t th e n so me f e a sibl e co mbin a tio n o f
a sse ts wo u l d l ie to th e r igh t o f th e ca pita l ma r ke t l in e , a n o bvio u s impo s-
sibil ity sin ce th e ca pita l ma r ke t l in e r e pr e se n ts th e e f f icie n t bo u n da r y o f
f e a sibl e va l u e s o f ER a n d OR.
T h e r e qu ir e me n t th a t cu r ve s su ch a s igg' be ta n ge n t to th e ca pita l
ma r ke t l in e ca n be sh o wn to l e a d to a r e l a tive l y simpl e f o r mu l a wh ich
r e l a te s th e e xpe cte d r a te o f r e tu r n to va r io u s e l e me n ts o f r isk f o r a l l a s-
se ts wh ich a r e in cl u de d in co mbin a tio n g.22 Its e co n o mic me a n in g ca n be st
be se e n if th e r e l a tio n sh ip be twe e n th e r e tu r n o f a sse t i a n d th a t o f co m-
bin a tio n g is vie we d in a ma n n e r simil a r to th a t u se d in r e gr e ssio n a n a l y-
sis.28 Ima gin e th a t we we r e give n a n u mbe r o f (e x po st) o bse r va tio n s o f
th e r e tu r n o f th e two in ve stme n ts. T h e po in ts migh t pl o t a s sh o wn in Fig.
8. T h e sca tte r o f th e R, o bse r va tio n s a r o u n d th e ir me a n (wh ich wil l a p-
pr o xima te ERi) is, o f co u r se , e vide n ce o f th e to ta l r isk o f th e a sse t
-
CRi.
Bu t pa r t o f th e sca tte r is du e to a n u n de r l yin g r e l a tio n sh ip with th e r e tu r n
o n co mbin a tio n g, sh o wn by Big, th e sl o pe o f th e r e gr e ssio n l in e . T h e r e -
spo n se o f R, to ch a n ge s in Rg (a n d va r ia tio n s in Rg itse l f ) a cco u n t f o r
22. T h e sta n da r d de via tio n o f a co mbin a tio n o f g a n d i wil l be :
o r =
V/a 2a Ri2 + (1
-
a )2 ORg2 + 2r ig a (l a ) cRia Rg
a t a = 0:
do 1
da L = d- [0Rg2
-
r j gcvRj a T gl
bu t o r = Rg a t a = 0. T h u s:
da
da
-
[cvRg
-
r iga Ril
T h e e xpe cte d r e tu r n o f a co mbin a tio n wil l be :
E =
a ERi
+ (1 - ca ) ERg
T h u s, a t a l l va l u e s o f a :
dE
dL
= _
[ERg -
ERJ]
a n d, a t a = 0:
dcv cvRg -
r igcf Ri
dE ERg-ERi
Le t th e e qu a tio n o f th e ca pita l ma r ke t l in e be :
CvR=
S(ER
-
P)
wh e r e P is th e pu r e in te r e st r a te . Sin ce
igg'
is
ta n ge n t
to th e l in e wh e n c = 0, a n d sin ce
(ERg, CvRg) l ie s o n th e l in e :
qp ~- r igq.,i dR
,Rg
- j gj
Rg
ERgERi ERg
P
o r :
E l + ERi.
r gRE [ERg-P LERg -P]
23. T h is mo de l h a s be e n ca l l e d th e dia go n a l mo de l sin ce its
po r tf o l io a n a l ysis
so l u tio n
ca n be f a cil ita te d by r e -a r r a n gin g th e da ta so th a t th e va r ia n ce -co va r ia n ce ma tr ix be co me s
dia go n a l . T h e me th o d is de scr ibe d in th e a u th o r 's
a r ticl e ,
cite d e a r l ie r .
Ca pita l Asse t Pr ice s 439
Re tu r n o n Asse t i (Ri)
,
.
~~~ig
-4..
ERi
Re tu r n o n Co mbin a tio n g (Rg)
FIGu RE 8
mu ch o f th e va r ia tio n in Ri. It is th is co mpo n e n t o f th e a sse t's to ta l r isk
wh ich we te r m th e syste ma tic r isk. T h e r e ma in de r ,24 be in g u n co r r e l a te d
with Rg, is th e u n syste ma tic co mpo n e n t. T h is f o r mu l a tio n o f th e r e l a tio n -
sh ip be twe e n R, a n d Rg ca n be e mpl o ye d e x a n te a s a pr e dictive mo de l . Big
be co me s th e pr e dicte d r e spo n se o f Ri to ch a n ge s in Rg. T h e n , give n ORg
(th e pr e dicte d r isk o f Rg), th e syste ma tic po r tio n o f th e pr e dicte d r isk
o f e a ch a sse t ca n be de te r min e d.
T h is in te r pr e ta tio n a l l o ws u s to sta te th e r e l a tio n sh ip de r ive d f r o m
th e ta n ge n cy o f cu r ve s su ch a s igg' with th e ca pita l ma r ke t l in e in th e
f o r m sh o wn in Figu r e 9. Al l a sse ts e n te r in g e f f icie n t co mbin a tio n g mu st
h a ve (pr e dicte d) Big a n d ER, va l u e s l yin g o n th e l in e PQ.25 Pr ice s wil l
24. e x po st, th e sta n da r d e r r o r .
25.
/Big20 Rg2
BigcRg
g
-
a Ri2 ORi
a n d:
-r igcvRi
Big
=- 4
o Rg
T h e e xpr e ssio n o n th e r igh t is th e e xpr e ssio n o n th e l e f t-h a n d side o f th e l a st e qu a tio n in
f o o tn o te 22. T h u s:
Big =
E-
Rg
P
+
[EgiP]
ERI.
440 T h e Jo u r n a l o f Fin a n ce
a dj u st so th a t a sse ts wh ich a r e mo r e r e spo n sive to ch a n ge s in Rg wil l h a ve
h igh e r e xpe cte d r e tu r n s th a n th o se wh ich a r e l e ss r e spo n sive . T h is a cco r ds
with co mmo n se n se . Obvio u sl y th e pa r t o f a n a sse t's r isk wh ich is du e to
its co r r e l a tio n with th e r e tu r n o n a co mbin a tio n ca n n o t be dive r sif ie d a wa y
wh e n th e a sse t is a dde d to th e co mbin a tio n . Sin ce Big in dica te s th e ma gn i-
tu de o f th is type o f r isk it sh o u l d be dir e ctl y r e l a te d to e xpe cte d r e tu r n .
T h e r e l a tio n sh ip il l u str a te d in Figu r e 9 pr o vide s a pa r tia l a n swe r to th e
qu e stio n po se d e a r l ie r co n ce r n in g th e r e l a tio n sh ip be twe e n a n a sse t's r isk
Big
Q
0
J______________
t ->f -P
~~~~~~~~~~ERi
Pu r e Ra te o f In te r e st
FIGURE 9
a n d its e xpe cte d r e tu r n . Bu t th u s f a r we h a ve a r gu e d o n l y th a t th e r e l a -
tio n sh ip h o l ds f o r th e a sse ts wh ich e n te r so me pa r ticu l a r e f f icie n t co m-
bin a tio n (g). Ha d a n o th e r co mbin a tio n be e n se l e cte d, a dif f e r e n t l in e a r
r e l a tio n sh ip wo u l d h a ve be e n de r ive d. Fo r tu n a te l y th is l imita tio n is e a sil y
o ve r co me . As sh o wn in th e f o o tn o te ,26 we ma y a r bitr a r il y se l e ct a n y o n e
26. Co n side r th e two a sse ts i a n d i*, th e f o r me r in cl u de d in e f f icie n t co mbin a tio n g
a n d th e l a tte r in co mbin a tio n g*. As sh o wn a bo ve :
Big
=
-[E1,g'P] +
[E P]
ERI
a n d:
Ca pita l Asse t Pr ice s 441
o f th e e f f icie n t co mbin a tio n s, th e n me a su r e th e pr e dicte d r e spo n sive n e ss
o f e ve r y a sse t's r a te o f r e tu r n to th a t o f th e co mbin a tio n se l e cte d; a n d
th e se co e f f icie n ts wil l be r e l a te d to th e e xpe cte d r a te s o f r e tu r n o f th e
a sse ts in e xa ctl y th e ma n n e r pictu r e d in Figu r e 9.
T h e f a ct th a t r a te s o f r e tu r n f r o m a l l e f f icie n t co mbin a tio n s wil l be
pe r f e ctl y co r r e l a te d pr o vide s th e j u stif ica tio n f o r a r bitr a r il y se l e ctin g a n y
o n e o f th e m. Al te r n a tive l y we ma y ch o o se in ste a d a n y va r ia bl e pe r f e ctl y
co r r e l a te d with th e r a te o f r e tu r n o f su ch co mbin a tio n s. T h e ve r tica l a xis
in Figu r e 9 wo u l d th e n in dica te a l te r n a tive l e ve l s o f a co e f f icie n t me a su r -
in g th e se n sitivity o f th e r a te o f r e tu r n o f a ca pita l a sse t to ch a n ge s in th e
va r ia bl e ch o se n .
T h is po ssibil ity su gge sts bo th a pl a u sibl e e xpl a n a tio n f o r th e impl ica -
tio n th a t a l l e f f icie n t co mbin a tio n s wil l be pe r f e ctl y co r r e l a te d a n d a u se -
f u l in te r pr e ta tio n o f th e r e l a tio n sh ip be twe e n a n in dividu a l a sse t's e x-
pe cte d r e tu r n a n d its r isk. Al th o u gh th e th e o r y itse l f impl ie s o n l y th a t
r a te s o f r e tu r n f r o m e f f icie n t co mbin a tio n s wil l be pe r f e ctl y co r r e l a te d,
we migh t e xpe ct th a t th is wo u l d be du e to th e ir co mmo n de pe n de n ce o n
th e o ve r -a l l l e ve l o f e co n o mic a ctivity. If so , dive r sif ica tio n e n a bl e s th e
in ve sto r to e sca pe a l l bu t th e r isk r e su l tin g f r o m swin gs in e co n o mic a c-
tivity-th is type o f r isk r e ma in s e ve n in e f f icie n t co mbin a tio n s. An d, sin ce
a l l o th e r type s ca n be a vo ide d by dive r sif ica tio n , o n l y th e r e spo n sive n e ss
o f a n a sse t's r a te o f r e tu r n to th e l e ve l o f e co n o mic a ctivity is r e l e va n t in
BJ*g*
=
[ERg* P
+
[E *-P]
ER11*
Sin ce Rg a n d Rg* a r e pe r f e ctl y co r r e l a te d:
r j *g* =
r j *g
T h u s:
Bi*g*o Rg*
Bi*gcr Rg
a n d:
[
ORg
B. =
Bi*g[
Cr j g
Sin ce bo th g a n d g* l ie o n a l in e wh ich in te r ce pts th e E-a xis a t P:
YRg ERg-P
(yRg* ERg*
P
a n d:
Bj *g*
=
Bi*g
P
T h u s:
-
[
]ER:P
+
[E
g p]
ERi* = Bi*g
[
E Pz]
f r o m wh ich we h a ve th e de sir e d r e l a tio n sh ip be twe e n
R,*
a n d g:
Bj *g[]
Er P+ [El IP]
Bi*g mu st th e r e f o r e pl o t o n th e sa me l in e a s do e s
Big.
442 T h e Jo u r n a l o f Fin a n ce
a sse ssin g its r isk. Pr ice s wil l a dj u st u n til th e r e is a l in e a r r e l a tio n sh ip
be twe e n th e ma gn itu de o f su ch r e spo n sive n e ss a n d e xpe cte d r e tu r n . As-
se ts wh ich a r e u n a f f e cte d by ch a n ge s in e co n o mic a ctivity wil l r e tu r n th e
pu r e in te r e st r a te ; th o se wh ich mo ve with e co n o mic a ctivity wil l pr o mise
a ppr o pr ia te l y h igh e r e xpe cte d r a te s o f r e tu r n .
T h is discu ssio n pr o vide s a n a n swe r to th e se co n d o f th e two qu e stio n s
po se d in th is pa pe r . In Pa r t III it wa s sh o wn th a t with r e spe ct to e qu i-
l ibr iu m co n ditio n s in th e ca pita l ma r ke t a s a wh o l e , th e th e o r y l e a ds to
r e su l ts co n siste n t with cl a ssica l do ctr in e (i.e ., th e ca pita l ma r ke t l in e ).
We h a ve n o w sh o wn th a t with r e ga r d to ca pita l a sse ts co n side r e d in -
dividu a l l y, it a l so yie l ds impl ica tio n s co n siste n t with tr a ditio n a l co n ce pts:
it is co mmo n pr a ctice f o r in ve stme n t co u n se l o r s to a cce pt a l o we r e xpe cte d
r e tu r n f r o m de f e n sive se cu r itie s (th o se wh ich r e spo n d l ittl e to ch a n ge s in
th e e co n o my) th a n th e y r e qu ir e f r o m a ggr e ssive se cu r itie s (wh ich e xh ibit
sign if ica n t r e spo n se ). As su gge ste d e a r l ie r , th e f a mil ia r ity o f th e impl ica -
tio n s n e e d n o t be co n side r e d a dr a wba ck. T h e pr o visio n o f a l o gica l f r a me -
wo r k f o r pr o du cin g so me o f th e ma j o r e l e me n ts o f tr a ditio n a l f in a n cia l
th e o r y sh o u l d be a u se f u l co n tr ibu tio n in its o wn r igh t.