The CAPM and APT - Finance Theory, MIT Lecture 15-17

15.401




15.401 Finance Theory
MIT Sloan MBA Program



Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School

Lectures 15–17: The CAPM and APT


© 2007–2008 by Andrew W. Lo

,Critical Concepts 15.401

ƒ Review of Portfolio Theory
ƒ The Capital Asset Pricing Model
ƒ The Arbitrage Pricing Theory
ƒ Implementing the CAPM
ƒ Does It Work?
ƒ Recent Research
ƒ Key Points

Reading
ƒ Brealey and Myers, Chapter 8.2 – 8.3




© 2007–2008 by Andrew W. Lo Slide 2
Lectures 15–17: The CAPM and APT

, Review of Portfolio Theory 15.401

Risk/Return Trade-Off
ƒ Portfolio risk depends primarily on covariances
– Not stocks’ individual volatilities
ƒ Diversification reduces risk
– But risk common to all firms cannot be diversified away
ƒ Hold the tangency portfolio M
– The tangency portfolio has the highest expected return for a given
level of risk (i.e., the highest Sharpe ratio)
ƒ Suppose all investors hold the same portfolio M; what must M be?
– M is the market portfolio
ƒ Proxies for the market portfolio: S&P 500, Russell 2000, MSCI, etc.
– Value-weighted portfolio of broad cross-section of stocks




© 2007–2008 by Andrew W. Lo Slide 3
Lectures 15–17: The CAPM and APT