The Mutual Fund Theorem and Covariance Pricing Theorems
This lecture continues the analysis of the Capital Asset Pricing Model, building up to two key results. One, the Mutual Fund Theorem proved by Tobin, describes the optimal portfolios for agents in the economy. It turns out that every investor should try to maximize the Sharpe ratio of his portfolio, and this is achieved by a combination of money in the bank and money invested in the "market" basket of all existing assets. The market basket can be thought of as one giant index fund or mutual fund. This theorem precisely defines optimal diversification. It led to the extraordinary growth of mutual funds like Vanguard. The second key result of CAPM is called the covariance pricing theorem because it shows that the price of an asset should be its discounted expected payoff less a multiple of its covariance with the market. The riskiness of an asset is therefore measured by its covariance with the market, rather than by its variance. We conclude with the shocking answer to a puzzle posed during the first class, about the relative valuations of a large industrial firm and a risky pharmaceutical start-up.
Source: Open Yale Courses
- Why Finance?
- Utilities, Endowments, and Equilibrium
- Computing Equilibrium
- Efficiency, Assets, and Time
- Present Value Prices and the Real Rate of Interest
- Irving Fisher's Impatience Theory of Interest
- Shakespeare's Merchant of Venice and Collateral, Present Value and the Vocabulary of Finance
- How a Long-Lived Institution Figures an Annual Budget Yield
- Yield Curve Arbitrage
- Dynamic Present Value
- Financial Implications of US Social Security System
- Overlapping Generations Models of the Economy
- Will the Stock Market Decline when the Baby Boomers Retire?
- Quantifying Uncertainty and Risk
- Uncertainty and the Rational Expectations Hypothesis
- Backward Induction and Optimal Stopping Times
- Callable Bonds and the Mortgage Prepayment Option
- Modeling Mortgage Prepayments and Valuing Mortgages
- Dynamic Hedging
- Dynamic Hedging and Average Life
- Risk Aversion and CAPM
- The Mutual Fund Theorem and Covariance Pricing Theorems
- Risk, Return, and Social Security
- Leverage Cycle and the Subprime Mortgage Crisis
- Shadow Banking: Parallel and Growing?