Chapter 7. Asset Pricing

We move from examining individual investors (a micro view) to the markets for assets and looking at the behaviour of all investors (a macro view). The crucial difference is the move from making statements about individuals to the drawing of conclusions about the behaviour of investors as a whole. It is this different focus that allows us to make statements about the pricing of financial assets. The capital asset pricing model (CAPM) was developed in the sixties by finance academics. It developed out of the mean–variance portfolio analysis described in the previous chapter. An important conclusion was that market prices reflect only part of a portfolio's risk. The part that is priced, the market-related risk, is measured by beta. The background to the CAPM is extensively discussed in Bodie et al. (1996), Chapter 8.

This chapter opens with the single-index model and illustrates the calculation of associated risk measures, in particular the estimation of betas and variance–covariance matrices from the returns of individual assets. The central numerical technique is regression, which is applied to estimate the beta of an asset, i.e. the return on the asset relative to the return on the market. The betas for a set of assets are useful in their own right to describe the relative responsiveness of assets to the market. However, they also facilitate the calculation of covariances via the single-index model. The EQUITY2.xls workbook contains implementations of the ...

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