CAPM - Equilibrium Theory

Discussion in 'P2.T8. Investment Management (15%)' started by dennis_cmpe, Oct 26, 2008.

  1. dennis_cmpe

    dennis_cmpe New Member

    In the study notes for CAPM Equilibrium Theory:

    1) All assets must be held in portfolios, including the risky asset portfolio.

    Sounds simple, but I'm not getting the importance of it. What does this mean? Why is this important?
  2. Dennis,

    The theoretical significance is that is paves the way for the capital market line (CML). It is an implication (not a premise of) the assumptions underyling the CAPM (assigned Chapter 4, Noel Amenc). If you consider the CAPM assumptions--they are really unrealistic so it is just setting up they theory--a key idea is that all investors have the exact same information about the same set of assets and they also use the same risk/return perspective. In short, the investors are clones of each other therefore they must reach the same conclusion. This homogeneity ensures inclusion of all risky assets: if a stock is avoided, then all will avoid it, and it's price goes to zero. But it is very attractive at zero, so in unison, the investor will like it even at some low price. I can't say i personally find this implication of equilibrium particularly important, but it's on the way to the more important CAPM idea that a security's return/risk owe not to its individual characteristics (e.g., standard deviation) but rather its risk contribution (i.e., beta) to the market portfolio.

    David

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