Summary of all the clips of Asset Pricing including lecture notes

Introduction lecture
Why are financial markets important?

(Scarce) capital → Banks and financial markets → projects.

Financial markets: allocating capital to its most productive use:
• Produce information-ex ante about possible investments and allocate capital
• Monitor investments and exert corporate governance after providing finance
• Facilitate the trading, diversification, and management of risk
• Most important reason why financial markets were started: Mobilize and pool
savings. (VOC – wanted to have more ships to trade goods. Problem was building a
ship was very capital investments – solution: sell of part of a company to attract
capital)
• Ease the exchange of goods and services
You can put your money into a bank who will put it into financial markets, or you can put it
directly into financial markets.

1. Asset pricing: what are the determinants of stock returns?
Why does one asset have a higher yield than another one?

2. Investments: How to optimize the performance of stock portfolio?
We focus on both: first examine return difference between stocks, then use this result as an
investor.

Asset pricing is something else than valuation.

Which markets?
- Equity
- Bonds
- Derivatives
- Real estate
We focus on equity only, and mainly in the United States.

Traditional process of investing
1. Form expectation about risk and return
2. Utility function + budget constraint
3. Buy and sell orders
4. Market returns

Many strong underlying assumptions
• Rational expectations
• Efficient markets
• Mean-variance utility
• Risk = variance
• Complete markets
What happens to asset prices if these assumptions are relaxed?
We take a more realistic approach in determining expected returns.


1

,Neo-classical versus behavioural finance
Neo-classical: investors are rational markets are efficient (Fama)
Behavioural: investors are boundedly rational, markets can deviate from efficiency (Schiller)

Behavioural process of investing




There is interaction between expectations and utility. (arrows up and down)
Form expectation:

Lecture 1 – Clip 1: Basics Portfolio Theory
Traditional process of investing
Form expectation about risk and return → Utility function + budget constraint → Buy & sell
orders → market returns

Portfolio theory focuses on how investors form expectations about risk and return.

If everybody behaviours according to portfolio theory and has certain utility functions, then
the market return behaves according to the Capital Asset Pricing Model. (CAPM)

Portfolio theory
First paragraph of his famous paper: the process of selecting a portfolio may be divided into
two stages. The first stage starts with observation and experience and ends with believe
about the future performances of available securities. The second stage starts with the
relevant beliefs about future performances and ends with the choice of portfolio. This paper
is concerned with the second stage. (Harry Markowitz, 1952)

Modern Portfolio Theory (MPT)
• Given expected returns, risks, and correlations
o MPT maximizes expected return given a certain level of risk, OR
o MPT minimizes risk given a certain level of expected return
• Focuses on the optimal combination of assets
o Diversification
o Irrespective of the investor’s utility function!
▪ Regardless of how many risk you want to take, MPT always holds


2

,Modern Portfolio Theory (MPT)
Warren Buffet uses a different approach: “Diversification is a protection against ignorance. It
makes very little sense for those who know what they are doing.”

Modern Portfolio Theory combines different assets, so you don’t make a deep analysis of
one asset. That is wat Buffet does do.

Buffet values stocks and decides to buy or sell them.
Asset pricing (or MPT) combines assets and you see what that combination does.

Portfolio theory
Portfolio return (N=2):
E(rP) = xaE(rA) + xBE(rB)

Assume:
E(rA) = 2%
E(rB) = 9%
XA = 50% (fraction of equity invested in share A)
XB = 50% (fraction of equity invested in share B)

E(rP) = 0.5 x 2% + 0.5 x 9% = 5.5%

Portfolio risk (n=2):
2(rP) = XA2 · 2 (rA) + XB2 · 2 (rB) + 2 · XA · XB · (rA) · ( rB) ·  (rArB)
E&BE: 𝑤𝑖2 𝜎𝑖2 + 𝑤𝑗2 𝜎𝑗2 + 2𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗
 (rArB) =  (rA) ( rB) 
𝜎𝑖𝑗
Take 3 situations: 𝜌𝑖𝑗 = → correlation
𝜎𝑖 𝜎𝑗
(rArB) = 1 no risk reduction: when return of asset i ↑, return of asset j ↑ as well
-1 <  (rArB) < 1 risk reduction
 (rArB) = -1 complete risk reduction: when return of asset i ↑, return of asset j ↓

Share E(r) (r)
A 2% 4%
B 9% 8%

Expected return:
E(rP) = xaE(rA) + xBE(rB)
= xa · 2% + xB · 9%
(xa + xB) = 1

If  is +1
2(rP) = XA2 · 2 (rA) + XB2 · 2 (rB) + 2 · XA · XB · (rA) · ( rB) · + 1 (rArB)
= [XA · (rA) + XB · (rB)] 2
(rP) = |XA · (rA) + XB · (rB)|




3

, Let’s create different combinations of A and B
P xB xB Return Risk
1 100% 0% 2.0% 4.0%
2 80% 20% 3.4% 4.8%
3 60% 40% 4.8% 5.6%
4 50% 50% 5.5% 6.0%
5 40% 60% 6.2% 6.4%
6 20% 80% 7.6% 7.2%
7 0% 100% 9.0% 8.0%




If  is 0
2(rP) = XA2 · 2 (rA) + XB2 · 2 (rB) + 2 · XA · XB · (rA) · ( rB) · 0 (rArB)
= XA2 · 2 (rA) + XB2 · 2 (rB)
(rP) =  [XA2 · 2 (rA) + XB2 · 2 (rB)]

Let’s create different combinations of A and B.
P xB xB Return Risk
1 100% 0% 2.0% 4.0%
2 80% 20% 3.4% 3.6%
3 60% 40% 4.8% 4.0%
4 50% 50% 5.5% 4.5%
5 40% 60% 6.2% 5.1%
6 20% 80% 7.6% 6.4%
7 0% 100% 9.0% 8.0%




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