Asset Pricing Theory

Professor Peter Bossaerts, Department of the Humanities and Social Sciences, Caltech

Since the early 50s, economists have been constructing a mathematical theory of financial markets, based on the premise that one ought not to be able to predict securities prices beyond a reasonable compensation for risk. The talk will focus on the prototype model, namely, the Capital Asset Pricing Model (CAPM). This model predicts that average returns in excess of the riskfree rate should be proportional to the covariance with the return on the market portfolio, or, equivalently, the ``beta.'' It is used in capital budgeting, industry regulation, takeover and merger valuation, investment analysis and fund management performance evaluation. But the scientific validity of the CAPM has been questioned. When based on (quite sophisticated!) statistical analysis of the historical record of established stock markets such as the NYSE, AMEX and NASDAQ, the evidence is indeed mixed at best. The talk will illustrate, however, when and how the theoretical predictions emerge in experimental financial markets organized at Caltech.