17-Capital Asset Pricing Model Page 511 Wednesday, February 4, 2004 1:10 PM

CHAPTER

17

Capital Asset

Pricing Model

T

he mean-variance approach to portfolio selection and its generaliza-

tions require a model for variance and expected returns to feed to the

optimizer. Asset price and/or return models belong to three different

families:

■ General Equilibrium Theories. These determine price processes as the

equilibrium between demand and supply of markets populated by eco-

nomic agents whose behavior is known. General equilibrium theories

are therefore truly economic theories based on specific assumptions on

the behavior of agents. The following models are general equilibrium

models: CAPM, Conditional CAPM, multifactor CAPM, and Con-

sumption CAPM.

■ Arbitrage Pricing Models. Arbitrage pricing is relative pricing inso-

far as the prices and therefore the returns of a set of assets depend

on another set of processes. Arbitrage pricing was discussed in

Chapters 14 and 15.

■ Econometric Models. These are statistical models of prices or returns.

They model prices or returns as endogenous phenomena and/or

establish links between prices and returns and exogenous variables.

The justification of econometric models is empirical, that is, they are

valid insofar as they fit empirical data. They are not derived from eco-

nomic theory although economic theory might suggest econometric

models. For example, Markov switching models are rooted in the the-

ory of economic cycles.

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