Prof. Dr.

Thorsten Hens
Nilufer Caliskan,
IBF@University of Zurich


Spring Term 2012
Advanced Financial Economics
Overview of the Class
1. Two-Period MV Model Chapter 3
2. Two-Period FME Model Chapter 4
3. Multi-Period FME Model Chapter 5



3. Mean-Variance Model
3.1 Introduction
3.2 Mean-Variance Analysis
3.3 Capital Asset Pricing Equilibrium
3.4 Extensions
3.5 Conclusion

3.1. Introduction
Markowitz (1952): Mean Variance Principle
Various reasons recommend the use of the expected return-
variance of return rule, both as a hypothesis to explain well-
established investment behavior and as a maxim to guide ones
own action.
Markowitz (1952): Portfolio Selection,
Journal of Finance 7, 77-91.
3.1. Introduction
Mean-variance analysis and the Sharpe-Lintner-Mossin CAPM
are widely viewed as one of the major contributions of academic
research in the post-war era.

Jagannathan and Wang (1996): The Conditional CAPM and the
Cross-Sections of Expected Returns, Journal of Finance 51, 3-53.


The CAPM is a rich source of intuition and also the basis for
many practical decisions.

Duffie (1988): Security Markets, MIT Press.
3.2 Mean-Variance Model
3.1 Introduction
3.2 Mean-Variance Analysis
3.3 Capital Asset Pricing Equilibrium
3.4 Extensions
3.5 Conclusion

3.2. Mean-Variance Analysis
Notation:
Assets k = 1, 2, , K
Gross return on asset k: R
k
Net return on asset k: r
k

Expected return on asset k:
k
= E(R
k
)
Standard deviation of returns on asset k:
k
= (E[(R
k

k
)
2
])
1/2
Return covariance between two assets j and k: cov
k,j
= E[(R
k

k
)(R
j

j
)]
Return correlation between two assets j and k:
Return on the riskless asset: R
f
j k
j k
j k

,
,
cov
=
The attractiveness of an asset can be characterized by the mean and
standard deviation of its returns.

.
.
.
.
.
.
.
.
.
R
f
k
k

3.2. Geometric Intuition MVA

3.2. Mean-Variance Analysis
Some Properties of Expectations, Variances and Covariances:
For a, b, , deterministic scalars, one has:
) , cov( ) , cov(
) var( ) var(
) ( ) (
2
j k j k
k k
k k
R R R b R a
R R a
R E a R a E



= + +
= +
+ = +
3.2. MVA- Diversification Portfolio of 2 Assets
Combining two risky assets k and j into a portfolio, with a fraction of wealth
invested in asset k, yields the following expected return and variance:

.
.
.
.
.
.
.
.
R
f
k
j
,
1
k j
=
,
1
k j
=
,
,
k j
k j
k j
COV

=
j k

) 1 ( + =
j k j k ,
2 2 2 2 2
cov ) 1 ( 2 ) 1 (

+ + =
3.2. MVA- Diversification Portfolio of K Assets
Letting
k
denote the fraction of wealth invested in asset k, one can compute
the minimum variance set by solving:










The upper part of the minimum variance set is called the Efficient Frontier.

.
.
.
.
.
.
.
.
R
f

= = =
k
k
k
p k k
k j
j k j k
const t s
K
1 , . . cov min
,
) ,..., (
1


3.2. MVA- Diversification MinimumVariance Set
We can rewrite the optimization problem in matrix form as:

It can be solved using the Lagrangian

The first-order conditions are:
1 1 ' , ' . . ' min = =

p
t s
) 1 ' 1 ( ) ' ( '
2
1
+ + =
p
L
0 1 ' 1
0 '
0 1
= =

= =

= =

L
L
L
p
3.2. MVA Diversification Minimum Variance Set
Hence, all minimum variance portfolios are of the form:

In order to determine the multipliers and , one just requires the constraints
to be satisfied:



Solving, the minimum variance portfolio with expected return
p
is given by:

1 1
1

+ =
1 ' 1 1 ' 1 1 ) 1 ( ' 1 ' 1
1 1 1 1
= + + = + =

B A
p p
C B = + + = + =
1 1 1 1
' 1 ' ) 1 ( ' '
0 , 0 ' , ' 1 , 0 1 ' 1
, ,
1
2 1 1 1
1 1
> > >

=
+ =


B AC C B A
B A B C
p p

3.2. MVA Diversification Minimum Variance Set
Using these results, the equation of the minimum variance set is:







Thus, the minimum variance set is a parabola.

( )

+
=
+ =
+ =
+ =
=

C B A
p p
p
p p





2
' 1 '
1 '
' ) (
2
1 1
2
3.2. MVA- The Efficient Frontier
Postwar yearly data on broad aggregates.
3.2. MVA-Preferences

Better
Worse
Mean-Variance Preferences:

2 2
2
) , (

i
i
U =
Indifference
Curve
More Risk
Averse
Less Risk
Averse
3.2. MVA Optimal Portfolio No R
f
Aggressive Investor Conservative Investor
3.2. Solving for the Optimal Portfolio No R
f
We begin by considering the case without a riskless asset.
The investors problem is

Set up the Lagrangian

The first-order condition is

The FOC says that the marginal utility of investing in all assets is the same, .
1 1 ' . . '
2
' max
2
max
2
= =

t s
i
p
i
p
) 1 ' 1 ( ' '
2


+ =
i
L
0 1= =

i
L
3.2. MVA Optimal Portfolio No R
f
The optimal portfolio as a function of is:

To determine , one imposes the constraint 1 = 1, yielding

Solving,

Substituting back into the expression for then yields the investors optimal
portfolio as a function of assets characteristics and the investors risk
aversion:
) 1 (
1
1

=

i
1 ) 1 ( ' 1
1
1
=

i
A
B
i i

1 ' 1
' 1
1
1

1 1 1
1
1
/ 1
) 1 (
1

+

= =
i
i
i
A
B
Postwar yearly data on broad aggregates.
3.2 Optimal Portfolio With R
f
Aggressive Investor Conservative Investor
3.2. MVA- Optimal Portfolio With R
f
Let us now turn to the case with a riskless asset. We index the riskless asset with 0.
As before, we let denote the fraction of wealth invested in the risky assets.
Thus, the fraction of wealth invested in the riskless asset is
0
= 1 1.
The portfolios expected return is now

The investors problem is therefore

The first-order condition is , yielding the optimal portfolio

+ ' ) 1 ( ' max

2
i
f f
R R
f p
R ) 1 ' 1 ( ' + =
0 1 =
i f
R
) 1 (
1
1
f
i
R =

3.2. MVA-Two-Fund Separation

Consider the optimal portfolio when there is a riskless asset:

Observe that this portfolio is identical for all investors up to scaling.
This result is called two-fund separation: all investors hold a combination of the
riskless asset and a portfolio of risky assets that is the same for all investors.
Thus, one can view investors portfolio selection problem as taking place in two
stages:
1. Computation of the optimal portfolio of risky assets, and
2. Based on risk aversion
i
, choice of the fraction of wealth invested in the
riskless asset and in the optimal portfolio of risky assets.
) 1 (
1
1
f
i
R =

Postwar yearly data on broad aggregates.

3.2. MVA-Two-Fund Separation

Aggressive Investor Conservative Investor
3.2. MVA- Computing the Tangency Portfolio
T
R
f
Postwar yearly data on broad aggregates.
3.2. MVA- Computing the Tangency Portfolio

The optimal portfolio of risky assets for all investors is the tangency portfolio.
It can be computed by normalizing the weights of the risky assets to sum to
unity.
Since , one has


The straight line going through the riskless asset and the tangency portfolio (in
the mean/standard deviation plane) is called the capital market line (CML). It
gives the best reward that investors can get for bearing risk.

) 1 (
1
1
f
i
R =

f
f
f
f
T
AR B
R
R
R

=


=

) 1 (
) 1 ( ' 1
) 1 (
1
1
1

3. Mean-Variance Model
3.1 Introduction
3.2 Mean-Variance Analysis
3.3 Capital Asset Pricing Equilibrium
3.4 Extensions
3.5 Conclusion

3.3 Capital Asset Pricing Equilibrium

The fact that all investors hold the same portfolio of risky assets makes it easy
to compute assets equilibrium expected returns.
When investors have mean-variance preferences, these expected returns are
described by the Capital Asset Pricing Model (CAPM).
We will look at two derivations of the CAPM and then consider how well the
model performs empirically by considering the profitability of a number of
trading strategies.

3.3. Capital Asset Pricing Equilibrium Proof 1

Recall that investor i holds the optimal portfolio

Compute the wealth-weighted average of the portfolio weights of all investors:

where
i
denotes investor is risk tolerance, aggregate risk tolerance, and W
total wealth (the sum of W
i
across investors).
But we know that the average portfolio must be the market portfolio, i.e. a
portfolio in which all assets enter according to their market capitalization.
Formally, at equilibrium we must have
) 1 (
1
1
f
i
i
R =

) 1 ( ) 1 ( ) 1 (
1
1
1
1
1
1
f
I
i
f i
I
i
f
i
i
I
i
i
i
R R R
W
W
W
W
= = =

=

=

=

M f M f
R R

= =

1
1 ) 1 (
1
3.3 The Capital Asset Pricing Equilibrium Proof 1

We cannot observe risk tolerance, but we can find it from market data. Pre-
multiplying the expression with
M
yields:

Rewriting,

Plugging this back into the expression for expected returns on the individual
assets, we get the CAPM equation

where is a vector whose kth element is

M M f M
R

1
) 1 (
M f
R

=
1
1
) ( 1
2
f M M
M
f M
f
R
R
R =

2
2
1 1
M
f M
M f M
R
R

= =
2
) , cov(
M
M k
k
R R

=
3.3 The Capital Asset Pricing Equilibrium- Proof 2


R
f
CML
j
Efficient Frontier
3.3. The Capital Asset Pricing Equilibrium Proof 2
The idea of the second proof is to use the fact that the slope of the CML and
the slope of the curve representing the risk/return combinations that can be
achieved by combining the market portfolio and an arbitrary asset j must be
the same when the weight of asset j is zero.
The slope of the CML is
The slope of the curve representing the combinations of asset j and the market
portfolio is

Equating the two slopes,

M
f M
R

M M M j
M j
M j M j d
d
M j d
d
R R
R R






/ ) ) , (cov(
| ) , cov( ) 1 ( 2 ) 1 (
| ) ) 1 ( (
2
0
2 2 2 2
0

=
+ +
+
=
=
) ( ) (
) , cov(
/ ) ) , (cov(
2
2
f M j f M
M
M j
f j
M
f M
M M M j
M j
R R
R R
R
R
R R
= =

3.3. The Capital Asset Pricing Equilibrium - SML
Expected returns on all assets are only driven by the sensitivity of assets
returns to the returns on the market portfolio, .







All assets lie on the so-called security market line (SML).

SML
1
M

f
R
2
) , cov(
), (
M
M j
j f M j f j
R R
R R

= =
3.3 The Capital Asset Pricing Equilibrium
Interpretation
Only systematic risk is rewarded by a risk premium.
This is because unsystematic risk gets diversified away investors should not
expect to receive a risk premium if they choose to bear unsystematic risk.
If the expected excess return on the market portfolio increases by 1% then the
excess return on asset k increases by
k
percent.
The SML is a relative valuation:

k
is the return required by the market to hold asset k.
If the systematic risk of an asset increases, its expected return has to increase.
1
) , cov(
), (
2
= = =
M
M M
M f M M f M
R R
R R

3.3. CAPM: The SML and the CML
(1 )
M
f
R R +



R
f
R
f
M
M
( ) ( )
( ) ( )
2
( (1 ) , )
SML: ( (1 ) ) ( ) ( ) .
( )
( (1 ) )
CML: ( (1 ) ) ( ) ( ) .
( )
M M
f M M M
f f f f f M
M
f M M M
f f f f f M
COV R R R
R R R R R R R R
R
R R
R R R R R R R R
R

+
+ = + = +
+
+ = + = +
3.3. CAPM: The Alpha and the Beta
1

1 K

( )
k f k M f
R R =

SML
1
M

( ) ( )
( , ) : ( ) ( )
k k M k k M
f f
R R R R R R =
K

f
R
3.3. CAPM: A Hedge Fund Application
Long/Short Equity:

r
SML
.
.
.
.
.
.
.
.
.
.
.
.
.
.
long
short
Market neutral
long
short
The Buzz Word Alpha
Many funds try to sell their investment strategy by pointing out a
positve alpha
Everybody seems to be hunting for the alpha
Is adding a positive alpha always good?
Adding it to efficient portfolios
Points to a direction of improvement
Adding it to inefficient portfolios
Can do worse if added in any amount
The Utility of Alpha Opportunities (1)
K
k
1
Let ( , ) ( - ) `cov ,
2
be the utilty at the portfolio R .
Taking the first derivative with respect to yields:
: ( ) cov( , ), 1,..., .
f
k
K
k k k k
f
k
V R
R R R k K

=
=

= =

The Utility of Alpha Opportunities (1)

k
k
At an optimum we know that 0, 1,...,
if 0. Moreover, can be different to zero for
not yet traded assets. Multiplying each of these equations
with and adding up we can eliminate the risk
k
k
k K

= =
>
k 0
,
k
aversion :
: ( ) ( (1 )),
cov( , R )
where withR .
var(R )
1
Hence, is the utility increase in the k-th direction.
k k
f f
k
R R
k
K
R
k k
R
k

=
= =

=
Alpha Opportunity => A portfolio above the CML

R
f
T
i
i
P
Switching to portfolio P
improves i` but not i.
However, both can improve
by investing some wealth in P.

Is adding positive alpha always good?
The reality put in a Mean-Variance Diagram
Client Portfolios
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0 0.05 0.1 0.15 0.2 0.25
stdev
m
e
a
n
client portfolios
1/N
max u
Adding Alpha Opportunities to Inefficient Portfolios

Benchmark Portfolio
New Product
YOUR Portfolio
Alpha is the direction of improvement starting at a benchmark portfolio
Exercise 1
An investor with mean-variance utility can invest in three risky assets,
k=1,2,3 and one risk-free asset. The risk free return is 2%. Risky assets cannot be
short sold. The expected returns of the risky assets are
1
=5%,
2
=7.5% and
3
=10%
The variance-covariance matrix is (denominated in %):

a. Calculate the tangential portfolio if the investor can only invest in the first two
assets. Calculate the mean and the variance and also the investor`s utilty for that
portfolio.
b. Now consider the third asset and show that it has positive alpha with respect to the
tangential portfolio. Suggest a new portfolio mix consisting of the tangential
portfolio and the third asset so that the investor improves upon the tangential
portfolio.
c. Now suppose the investor had initially chosen the portfolio consisting of asset 2
only. Show that adding asset three to this portfolio makes him worse off!
2 1 2
1 4 6
2 6 8
COV
| |

|
|
|

\ .
=
2
( , ) V =
3.3 CAPM: The Market Portfolio
Market capitalizations of all traded risks
Example: Stocks to Bonds 50:50
MSCI-CH 3%, MSCI-US 54% MSCI-UK 10% as of MSCI-World
Bonds-US 44.26%, Bonds-CH 0.13%, Bonds-D 9.17% vom Bond-
Index
REITS 10%
HFs 5%

3.3. Empirical Properties of the CAPM
- Investors do not hold portfolios with the same proportion of risky assets!
- Market Portfolio is inefficient
- Tangential Portfolio is under-diversified
- Size-Puzzle
- Value-Puzzle
3.3. Fama und French (JF 1992) B/M
July 1963 to December 1990, mntl returns NYSE, AMEX, Nasdaq

Mntl returns:
Book/Market
low high
1A 1B 2 3 4 5 6 7 8 9 10A 10B
Mntl. returns in % 0,30 0,67 0,87 0,97 1,04 1,17 1,30 1,44 1,50 1,59 1,92 1,83
Beta 1,36 1,34 1,32 1,30 1,28 1,27 1,27 1,27 1,27 1,29 1,33 1,35
The 12 Portfolios have almost identical Beta but quite different excess returns.

Contradiction to CAPM!
3. Mean-Variance Model
3.1 Introduction
3.2 Mean-Variance Analysis
3.3 Capital Asset Pricing Equilibrium
3.4 Extensions
3.5 Conclusion

3.4 Extensions of the CAPM
a. Heterogeneous Beliefs
b. Background Risk
c. Behavioural Preferences

3.4.a. CAPM with Heterogenous Expectations

Introduction
SML in CAPM with Heterogeneous Expectations
Individual Security Line
Zero Sum Game?
Active and Passive Investment

Reference: Gerber and Hens (2009):
Modeling Alpha Opportunities Within the CAPM, NCCR-Working paper.
Ineichen (2005), The critique of pure alpha, page 31.
Equities, bonds and other traditional asset classes have an economic
rationale for giving positive mean returns. Hedge funds have no
economic theory underlying their positive performance. There is no
risk premium in the classic economic sense. The returns are achieved
by the managers. ability to exploit inefficiencies left behind by other
(less informed, less intelligent, less savvy, ignorant, or uneconomically
motivated) investors in what is largely considered a zero or negative
sum game.

Example Heterogenous Expectations
Siebenmorgen&Weber Bonds Blue Chips Small caps Foreign stocks
Befragungsbogen Expected return Expected return Expected return Expected return
1 5.1% 14.3% 9.0% 10.0%
2 4.9% 0.5% 7.0% 0.5%
3 5.7% 12.3% 15.0% 15.0%
4 14.9% -1.0% 14.9% 0.0%
5 3.0% 11.5% 5.0% 15.0%
6 3.9% 13.5% 8.5% 13.5%
7 5.4% 30.0% 40.0% 30.0%
8 4.5% 10.6% 11.7% 13.2%
9 5.0% 10.0% 38.0% 38.0%
10 6.2% 8.7% 13.3% 30.0%
11 2.8% 13.5% 13.5% 13.5%
12 0.8% 7.1% 6.2% 7.1%
13 4.1% 9.6% 11.2% 8.7%
14 4.7% 6.2% 7.0% 7.8%
15 1.9% 14.8% 13.5% 10.8%
16 4.5% 15.0% 10.0% 12.0%
17 6.0% 5.8% 30.0% 20.0%
18 4.6% 7.9% 11.7% 6.2%
19 4.0% 20.1% 31.5% 37.8%
20 3.8% 6.4% 4.5% 5.4%
21 5.6% 11.5% 18.5% 13.5%
22 3.9% 20.0% 23.5% 24.0%
23 11.5% 9.1% 18.0% 0.0%
Mittelwerte 5.1% 11.2% 15.7% 14.4%
Stdw. 2.9% 6.5% 10.2% 11.0%
Siebenmorgen and Weber (2003): A Behavioural Model for Asset Allocation, JFMPM
Assumption for CAPM with heterogenous beliefs
Assumption: Heterogenous means but homogenous covariances
Why? Size of errors in means versus covariances:
2
1
1
( , )
2
1
Optimal portfolio: = ( )
Hence the optimal utility value is:
1
( ) ( )
2
That is to say errors in mean lead to quadratic deviations
while errors are of the order -1.
f
opt
f f
V
COV R
V R COV R

=
See Gerber and Hens (2009) for case of heterogenous covariances.
CAPM with Heterogenous Expectations

Introduction
SML in CAPM with Heterogeneous Expectations
Individual Security Line
Zero Sum Game?
Active and Passive Investment

Reference: Gerber and Hens (2009):
Modeling Alpha Opportunities Within the CAPM, NCCR-Working paper.
( )
( )
i
M,k i,k
1
M
1
M
Starting frommax ( ) , we get
2
1
, multiplying with the relative wealth
and summing up we get, using = :
, which is equivalent to:
cov(R,R )
i
i i i i
f
i i
f
i
I
i
i
i
I
i
f
i
i
R COV
COV R r
r
r
COV R

=
=

=
=

( )
( )
M,k
1
M , , , M,k
1 1
. Multiplying with and summing up:
var(R ) , where .
i
I
i
f
i
i
i
I K
i M i M i k
f
i
i k
r
R
r
R

=
= =
=
= =

CAPM (with heterogeneous beliefs)
CAPM (with heterogeneous beliefs)
( )
( )
( )
M M,k
1
M , , , M,k
1 1
1
M
1
(1) cov(R,R ) . Multiplying with and summing up:
(2) var(R ) , where .
Dividing (1) and (2) by we obtain:
cov(R,R )
(1`) , wher
i I
i
f
i
i
i I K
i M i M i k
f
i
i k
i I
i
i
f
i I
i
i
r
R
r
R
r
R
r

=
= =
=
=
=
= =
=

( )
1
1
M
,
1
1
e
var(R )
(2`) , where .
i
a
i
r
I
i
i
i
I
r
i
i
i
I
M M i M
f
i I
i
i
i
i
R a
r

=

=
=
=
=
= =

CAPM (with heterogeneous beliefs)

( )
( )
M
1
1
1
M
,
1
1
1
M
M
cov(R,R )
(1`) , where
var(R )
(2`) , where .
Eliminating from (2`) and inserting in (1`) one obtains:
cov(R,R )
(1*)
var(R )
i
a
i
r
I
i
i
f
i I i
I
r
i
i
i i
i
I
M M i M
f
i I
i
i
i
i
I
i
i
R
r
i
R a
r
r

=

=
=
=
=
=
= =
= =

( ) ( )
( ) ( )
k
= , which reads for asset k:
= , which is the SML with averaged expectations.
k
M
f f
k M
f f
R R
R R

The Security Market Line (SML)

( )
k f k M f
R R =

SML
1
M

where
k
= COV
kM
/
2
M
f
R
CAPM with Heterogenous Expectations

Introduction
SML in CAPM with Heterogeneous Expectations
Individual Security Line
Zero Sum Game?
Active and Passive Investment

Reference: Gerber and Hens (2009):
Modeling Alpha Opportunities Within the CAPM, NCCR-Working paper.
Individual Security Line (ISL)
,
, 2 ,
where ( , ) / ( )
i opt
i opt i opt
k k
COV R R R

=
,
,
( )
i opt
i opt
i
k f k f
R R

=
i

ISL
1
, i opt
i

f
R
( )
( )
( ) ( )
i i
2 i i
0
i
, i
0 2 i
1

1
( ) ( ) (1 )
( , )
( ) (1 )
( )
i
f i
i
f i
k
i k i
f f
COV R
R
COV R R
R R

=
=
=
CAPM with Heterogenous Expectations

Introduction
SML in CAPM with Heterogeneous Expectations
Individual Security Line
Zero Sum Game?
Active and Passive Investment

Reference: Gerber and Hens (2009):
Modeling Alpha Opportunities Within the CAPM, NCCR-Working paper.
Market return break up by assets and by investors (1)
Asset Allokation AnlageklassenSGB FGB SPI CBE MSCI-E MSCI-US MSCI-AP Cdty. Hedge Performance
Investoren rel Vermgen 2% 4% 10% 6% 7% 10% -7% 30% -4% Summe Investoren
PK1 5.59% 25.00% 15.00% 16.25% 5.00% 20.00% 6.25% 1.25% 5.00% 6.25% 100% 6.2%
PK2 8.38% 33.71% 3.37% 17.98% 3.37% 13.48% 6.74% 10.11% 2.25% 8.99% 100% 4.0%
PK3 11.17% 21.13% 8.45% 21.13% 2.82% 15.49% 22.54% 4.23% 2.82% 1.41% 100% 6.9%
PK4 5.59% 23.47% 1.41% 23.47% 1.41% 11.27% 28.17% 8.92% 0.94% 0.94% 100% 6.2%
Vers 1 2.79% 23.04% 3.25% 28.73% 0.00% 8.95% 12.01% 12.01% 0.00% 12.01% 100% 4.0%
Vers 2 8.38% 20.35% 8.72% 32.56% 1.74% 5.23% 8.72% 14.53% 2.33% 5.81% 100% 4.8%
Vers 3 13.97% 15.75% 13.75% 33.80% 3.44% 0.86% 3.19% 16.04% 4.01% 9.17% 100% 4.5%
Vers 4 5.59% 9.57% 15.79% 29.67% 4.31% 2.87% 7.63% 14.84% 4.79% 10.53% 100% 5.0%
Familie1 2.79% 1.79% 6.03% 9.33% 1.72% 1.94% 20.44% 4.88% 1.87% 52.01% 100% 1.6%
Familie2 2.79% 0.42% 4.31% 5.74% 1.27% 1.77% 13.43% 3.12% 1.35% 68.58% 100% -0.3%
Familie3 8.38% 0.14% 3.37% 3.99% 1.01% 1.60% 9.87% 2.25% 1.07% 76.69% 100% -1.2%
Familie4 13.97% 0.61% 4.19% 4.49% 1.28% 2.19% 11.66% 2.61% 1.34% 71.64% 100% -0.6%
Familie5 5.59% 0.39% 1.73% 1.70% 0.53% 0.96% 4.61% 1.02% 0.55% 88.51% 100% -2.6%
Herr x 2.79% 2.03% 7.06% 6.49% 2.19% 4.14% 18.26% 3.98% 51.14% 4.71% 100% 18.1%
Herr y 1.40% 1.60% 4.72% 4.08% 1.47% 2.88% 11.87% 2.56% 67.68% 3.15% 100% 22.1%
Frau x 0.56% 1.35% 3.55% 2.91% 1.12% 2.23% 8.73% 1.86% 75.86% 2.37% 100% 24.1%
Frau y 0.28% 6.18% 14.83% 11.58% 4.68% 9.56% 35.72% 7.55% 0.00% 9.89% 100% 5.5%
Summe 100.00% 13.26% 7.34% 17.76% 2.30% 6.37% 11.43% 7.52% 5.05% 28.96% 100% 3.891899%
M A R K T P O R T F 3.891899%
The market has the average performance of the investors!
Market return break-up by assets and by investors (2)
i,k
k,M ,
1
Let be the percentage of wealth investor i devotes to asset k
Then is the market capitalization of asset k,
where is the relative wealth of investor i, invested in risky assets,
I
i k i
i
i
r
r

=
=

0 0
1
,
1
,
1 1
i ,
1 1
,
1 1
i.e. / , (1 ) .
Define : , the market return.
Hence: ,
Or: , where R .
Market breakup: .

I
i i i i i i
f f f
i
K
M k M k
k
K I
M i k k i
k i
I K
M i i i k k
i k
I K
M i i k M k
i k
r w w w W
R R
R R r
R R r R
R R r R

=
=
= =
= =
= =
= =
=
=
= =
= =

Zero Sum Game (A First Cut)
( )
1
1
Recall: . Hence:
We cannot all be better than average:
0. Is this also true
when we take risk adjustment into account?
I.e. does the zero sum game prope
i
I
M i i
i
I
i M i
i
outperformance
R R r
R R r
=
=
=
=

rty also hold for the alpha?

Alpha and Beta (ex ante)
,1 i

, j K

( )
k f k M f
R R =

SML
1
M

( ) ( )
,
( , ) : ( ) ( )
i k k M i k k M
f f
R R R R R R =
, i K

,1 j

f
R
Properties of Alphas (ex ante): Zero Sum Game
( ) ( )
( )
,
i , ,
1
i
1 1
M
, , , ,
1 1 1 1
Recall: ( , ) : ( ) ( )
Define the alpha of investor i: ( , )
Claim: = 0, where a / . Proof:
i k k M i k k M
f f
K
M k i k k M
k
I I i i
i
i i
i i
I K I K
M k i k M k i k k
f
i k i k
R R R R R R
R R
r r
i
a
i i
a a R

=
= =
= = = =
=
=
=
=

( )
( )
( )
( ) ( )
M
, , ,
1 1 1 1
M
=
= 0
f
I K I K
M k i k M k k
f f
i k i k
M
M
f f
R
i i
a R a R
R R


= = = =
| |
|
\ .

=

Even before we know who is right we can agree t hat we cannot
all be bet t er (adj ust ing for risk) t han t he average.
Alpha and Beta (ex post)
j

( )
f k f k M
R R =

SML
1
M

( )

( )
( , ) : ( ) ( )
k
k M k k M
f f
R R R R R R =
K

f
R
Fix your asset allocat ion according t o your beliefs
and let it run for some t ime. Check t he result ing alpha.
Properties of Alphas (ex post): Zero Sum Game

( )

( )

( )

( ) ( )

i
,
1
1
K
, ,
1 1 k=1
Recall: ( , ) : ( ) ( )
Define the alpha of investor i: ( , )
Claim: = 0. Proof:
= ( ) ( )
=
k
k M k k M
f f
K
k
i k k M
k
I
i
i
I K
k
i k M k k k M
f f
i k
M
R R R R R R
R R
i
r
i
r R R R R

=
=
= =
=
=

( )

( )
M
0
M
f f
R R =
Even adj ust ing for risk we cannot all be bet t er t han average.
Alpha and Beta (a wrong comparison):
no zero sum game
,1 i

, j K

,1 j

( )
k f k f M
R R =

SML
1
M

( )

( )
,
( , ) : ( ) ( )
i k k M i k k M
f f
R R R R R R =
, i K

f
R
We can al l be wr ong!

Consistency of Alphas (ex post = ex ante)?

( )

( )

( ) ( )
i
,
1
,
i , ,
1
Ex-post: ( , ) : ( ) ( )
Define the alpha of investor i: ( , ).
Ex-ante: ( , ) : ( ) ( )
Define the alpha of investor i: ( , )
Note
k
k M k k M
f f
K
k
i k k M
k
i k k M i k k M
f f
K
M k i k k M
k
R R R R R R
R R
R R R R R R
R R




=
=
=
=
=
=

i
, if then = .
i
=
Taxonomy of Gains


( )

( )
( )

( )
,
1
i
,
1
i 1
Monetary Gain:
Risk Adjusted Gain:
( ) ( )
1
Utility Gain: U ( , ) ( ) ( ),
1
where .
K
i
i k
k
K
i k k k M
f f
k
i i i i
i
i
f
i
R R
R R R R
R R
COV R

=
=

=
=
=
=

The market is NO Zero-Sum Game in terms of utilities

because there are gains from trade!
CAPM with Heterogenous Expectations

Introduction
SML in CAPM with Heterogeneous Expectations
Individual Security Line
Zero Sum Game?
Active and Passive Investment

Reference: Gerber and Hens (2009):
Modeling Alpha Opportunities Within the CAPM, NCCR-Working paper.
Active and Passive Management
Passive means to buy and hold the market portfolio:
You get the beta.
Active means to be not passive
So who shall be active then?
This depends on your information.
An active investor beliefs to get some positive reward over and above
the SML: The alpha.
So who shall be active?
1
1
,
2
1
1
Recall the optimal asset allocation of an active manager:
1
( )
If an active Manager adapts the market expectations, we see:
( ), where .
Hence:
(
1
i
f
i
k M
i M k
f f
M
M
f M
i
COV R
COV
R R
R
COV COV

=
= + =

=
2
1
2
)
Therefore, he is passive!
( )
1
M
M
f M
i M
Skalar
R

Active-Passive Decision
Passive: Hold the market portfolio, i.e. set ;at no cost!
utility:
Active: Form your own beliefs and optimize: Costs C
i
.
utility:
i
=

2 2
0 0 1 0 1
( ) (1 ) ( ) (1 ) ( ) .
2
i
i i i i i i i i
f
U R R R C

= +
` `
: solves ( ) .
2
i
i i i i i
f
Note R COV

2 2
1 1
0 0 0
( ) (1 ) ( ) (1 ) ( ).
2
i
i i i i
f
U R R R

= +


2 2
in
2
` 1
Active or Passive?
1
( ) ( ) ,
2
where .
i i i i i
i
market efficieny prediction error
skill
U U C
x x COV x

| |
|
|
= >
|
|
|
|
\ .
=

Active or Passive?
The more inefficient the market, the more active you should be.
The more skilled you are, the more active you should be.
The smaller the cost, the more active you should be.
The less risk averse you are, the more active you should be.

Exercise 2 ( )
Show that investor 1 has a positive alpha but should rather be passive!
Risk Aversion in this exercise's notation =
3.4 Extensions of the CAPM
a. Heterogeneous Beliefs
b. Background Risk
c. Behavioural Preferences

3.4.b. CAPM with Background Risk
Tangential Portfolio Market Portfolio
Various Risks in Tangential Portfolio
Background Risk: Risk factors you care about (1)
If you care about liquidity risk and I don`t we shall trade.
If you care about being contrarian and I don`t we shall trade.



3.5 From CML to SML (2)


R
f
CML
j
Efficient Frontier
Optimal portfolio
Analogously to 3.5 we arrive at:
2
1
1
( )
where
( , )
Suppose , one of which may be
then ( ), which is the APT.
j F jT T f
j T
jT
T
F
T f f M
f
F
j F jf f f
f
R R
COV R R
R R R
R R

=
=
=
=
=
=

A precise argument is given in Chapter 4.4.4 of Hens and Rieger (2009)

3.4 Extensions of the CAPM
a. Heterogeneous Beliefs
b. Background Risk
c. Behavioural Preferences

Behavioural CAPM
Prospect Theory
A Behavioural Evaluation of the FF-data
A Behavioural SML
Prospect Theory
Reference Point
Gains and Losses
Loss Aversion
Decreasing Marginal Utility from Gains
Decreasing Marginal Suffering from Losses
Probability Weighting
Kahneman and Tversky (1979): Prospect Theory, Econometrica, 17, 263-291.

( ) ( ) ( )
u s s
s
PT c w p u c =

PT-value function
by De Giorgi, Hens and Mayer
2
MVA is special case!
If , and 1
Then ( ) - .
2
RP
u x RP

+
= = =
+ =
-2
-0.5
1
-1 0 1
Gains Losses
-x
x
x(
+
/2)(x)
2
(x(

/2)(x)
2
|
Reference point
2
2
Quadratic function:
( ) if 0
2
( )
( ) if 0
2
where
x x x
u x
x x x
x x RP

>

=

| |

<
|

\ .

=
Behavioural CAPM
Value Functions of Prospect Theory
A Behavioural Evaluation of the FF-data
based on DHL-Value Function
A Behavioural SML
PT and the Size and Value Premium Puzzle
Caliskan summer research paper
Some Statistics: Execss Kurtosis
negative excess kurtosis positive excess kurtosis
4
4
( )
3
E x

Some Statistics: Skewness
negative skewness positive skewness
3
3
( ) E x

Evaluating MV and PT (Benchmark Portfolios)

Caliskan summer research paper
Behavioural CAPM
Value Functions of Prospect Theory
A Behavioural Evaluation of the FF-data
A Behavioural SML
Based on DHM-value function
A Reward Risk Perspective on Prospect Theory
pt-
pt+
DeGiorgi, Hens and Mayer (2011), Finance Research Letters
( ) ( ) ( ),
where ( ) ( )
and ( ) ( )
( )
where v(c)= 1
- ( )
s
s
u
s s
c RP
s s
c RP
PT c pt c pt c
pt c p v c
pt c p v c
u c c RP
u c c RP

+
+
>

<
=
=
>

<

Same Procedure as before
Pt+
Pt-
0
j
Efficient Frontier
Optimal portfolio

Details (1)
{
( ) 0
2
Let ( ) (1 ) , for 1,..., .
( (1 ) ) ( ( ) ) (1 )( ( ) )
( ( ) ) (1 )( ( ) )
2

j M
j M s j M
s
j M
s R R RP s S
pt R R p R s RP R s RP
R s RP R s RP

+
>
+
= + =
+ = +

( +
`

)

{
{
( ) 0
2 2 2 2
( ) 0
0
= ( ( ) ) (1 )( ( ) )
( ( ) ) (1 ) ( ( ) )

2 2 (1 )( ( ) )( ( ) )
( (1 ) )
( ( ) ( ))
s j M
s
j M
j M
j M
s j M
s
p R s RP R s RP
R s RP R s RP
R s RP R s RP
dpt R R
p R s R s
d

>
+
+
>
=
+

( +

(
`
+
(

)
+
=

}
( ( ) ( ))( ( ) )
For ( (1 ) ) we get analoguous expressions.

j M M
j M
R s R s R s RP
pt R R

Details (2)
{ }
{
0 0
( )
( )
The optimality condition is:
( (1 ) ) ( (1 ) )

( ( ) ( )) ( ( ) ( ))( ( ) )

( ( ) ( )) ( ( ) ( ))(
M
M
j M j M
s j M j M M
R s RP
s j M j M
R s RP
dpt R R dpt R R
d d
p R s R s R s R s R s RP
p R s R s R s R s R

+
= =
+
>

<
+ +
=

=

}
( ) )
M
s RP
B-SML
dpt-
dpt+

M
j
3. Mean-Variance Model
3.1 Introduction
3.2 Mean-Variance Analysis
3.3 Capital Asset Pricing Equilibrium
3.4 Extensions
3.5 Conclusion

3.5 Conclusion
CAPM is a good model to study the effects of diversification!
CAPM cannot include derivatives one needs to model more
fundmentally the principle of no-arbitrage!
CAPM has no dynamics (expetations, wealth) one needs to extend it
to multiple periods!