An Analysis Of Merton's Intertemporal Capital Asset Pricing Model

The investor 's objective is to maximize the portfolio 's expected return, subject to an acceptable level of risk (or minimize risk, subject to an acceptable expected return). The assumption of a single time period, coupled with assumptions about the investor 's attitude toward risk, allows risk to be measured by the variance (or standard deviation) of the portfolio 's return. Thus, as indicated by the arrow in Figure 1, the investor is trying to go as far northwest as possible. As securities are added to a portfolio, the expected return and standard deviation change in very specific ways, based on the way in which the added securities co-vary with the other securities in the portfolio. An investor who can live with a lot of risk might choose …show more content…
Merton 's (1973) intertemporal capital asset pricing model (ICAPM) was developed to capture this multi-period aspect of financial market equilibrium. We still don 't know exactly how many factors there are, but the ICAPM at least gives us some guidance.

Consumption-Oriented Capital Asset Pricing Model The consumption-based model of Breeden (1979) provides a logical extension of the previous work in asset pricing. Based on this "diminishing marginal utility of consumption," securities that have high returns when aggregate consumption is low will be demanded by investors, bidding up their prices (and lowering their expected returns). In contrast, stocks that co-vary positively with aggregate consumption will require higher expected returns, since they provide high returns during states of the economy where the high returns do the least good.

Based on this line of reasoning, Breeden derives a consumption-based capital asset pricing model (CCAPM) of the form:

CCAPM E(Rj) = Rf + ßjC [E(Rm) -
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