FIN 010 Lecture Notes - Lecture 25: Santa Barbara City College, Idiosyncrasy, Capital Asset Pricing Model
Document Summary
Overcome shortcomings of capm, less restrictive assumptions, empirically testable (doesn"t require quadratic preference functions or norm dist. ) Law of one price, no special role for market portfolio. Arbitrage: riskless profit, securities to be mispriced). > multifactor version of sml however multifactor model = no more than a. Non-diversifiable risk (factor risk) = requires risk premium, diversifiable risk foes not description. Large asset markets (sufficient securities diversify away idiosyncratic risk) Asset returns = linear factor structure (eg. sim) Market permits no arbitrage opportunities (no mispricing) Driven by k" factors (common, systematic, economy-wide sources, sim to sim) Assumptions: unlimited number of securities, unlimited short selling, one factor price assets. To preclude arbitrage opps, e(r) on well all-diversified portfolios must lie on straight line from risk-free asset. Suppose relo b/w e(ri) and bij is non linear. Arbitrage ensures a linear relo b/w risk and return in equilibrium.
