2. General Equilibrium Asset Pricing Models

Asset pricing models seek to value securities and other assets based on their risk. If the risk of an asset can be accurately measured, its rate of return can be estimated. Following the basic finance axiom that higher risk implies higher returns, asset pricing models are central to the question of valuation. The field of asset pricing models as a branch of financial economics has its origins in the now famous Capital Asset Pricing Model (CAPM) by William Sharpe (Journal of Finance 46:209–237, 1964). The CAPM builds upon Harry Markowitz’s (Journal of Finance 7:77–91, 1952, Portfolio selection: Efficient diversification of investments. Wiley, New York, 1959) mean-variance investment parabola covered in the last chapter. Together, Markowitz and Sharpe shared the Nobel Prize in Economics in 1990 (along with Merton Miller). A number of other researchers are credited for contemporaneously creating similar versions of the CAPM, including Jack Treynor (Market value, time, and risk, 1961, Toward a theory of market value of risky assets, 1962), John Lintner (1965), and Jan Mossin (Econometrica 34:768–783, 1966). The CAPM is a revolutionary model derived in a general market equilibrium setting that introduced a new measure of risk known as beta risk (or \(\beta\)) related to the market factor. This breakthrough model stimulated a tremendous amount of research and professional applications that continues today. Unfortunately, early empirical tests of the CAPM using U.S stock returns were weaker than expected. The statistical relation between stock returns and beta risk was relatively flat. In an attempt to better adapt the CAPM to real world evidence and account for this flat relationship, Fischer Black (Journal of Business 45: 444–454, 1972) proposed the zero-beta CAPM with two factors: (1) a market factor plus (2) an orthogonal zero-beta portfolio factor. Also, other researchers proposed further changes to the CAPM in an effort to bolster its applicability to real world markets. In this chapter we review the CAPM, zero-beta CAPM, and other CAPM-based models. Our interest is to review the foundation of theoretical asset pricing models. In forthcoming Chapters 4 and 5, we build upon this foundation by discussing the theoretical and empirical ZCAPM, respectively. The ZCAPM will be used in later chapters to build diversified, efficient investment portfolios.