Doctoral Seminar in Asset Pricing
Lecture Note 1
The Capital Asset Pricing Model
1. Introduction
Suppose that you, as a risk averse investor, wanted a simple rule for choosing between
various investment alternatives. One rule that you might consider is to select the
investment that delivers the highest expected return for a given level of variance.
That is, you might decide that you wanted to maximize expected return and minimize
variance. Even if you had only a passing familiarity with economic theory, you would
probably agree that this approach sounds quite sensible. Later on, we will see that
the mean-variance rule of portfolio selection is fully consistent with expected utility
maximization only under special circumstances. For the moment, however, we want to
consider how an investor might behave under circumstances where the mean-variance
approach is optimal.
1.1. Diversi¯cation
We begin with the following two assumptions:
1. Investors are risk averse.
2. Investors seek to maximize expected return and minimize variance.
Under these conditions, all investors will want to hold diversi¯ed portfolios. The
reason is that diversi¯cation reduces variance.
A Simple Example
Take the case of a portfolio formed from two assets. The expected return on this
portfolio is given by the formula
Ep = X1E1 + X2E2
1