Nigel Williamson T.

Lee 2008-21650 BA146: CAPM from CCAPM The objective is to derive the Capital Asset Pricing Model (CAPM) from the Consumption-CAPM or CCAPM. To do this, we must start with the utility formula that defines the CCAPM which is given by equation [1]. ( S.t. ) ( ) [1]

Substituting the constraints into the utility function ( ) ( )

Getting the first derivative of this function with respect to Z, the number of assets bought ( )( )( ) ( ) [ ( ) ( )( ) ( ) [ ( )

Now looking at this equation, we can interpret it as the price of assets given by the discounted future payoff. ( ) ( ) The marginal utility can also be called m, or the SDF (Stochastic Discount Factor which have several other names). So we can re-write the above equation simply as, [2] By dividing equation [2] by Po, we restate the equation by representing it with respect to Po or 1 dollar. [3]

Now recall that (

( ) ( )

). Using that property for equation [3], we derive ( ) ( ) ] ( )

( ) ( ) ( )[ ( )

For the next step, recall equation [2]. If it were a risk free asset then the discount factor m would be with Rf being the risk-free rate. So E(m) = ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ( ) ) ( ( ))

The equation above is the central idea of the Consumption-CAPM where the risk premium given by ( ) is equal to the negative covariance of the marginal utility and the payoff. Simply put, this equation states that the equity premium will be high when consumption is high (and MU is therefore low). In contrast, the premium is low when consumption is low (but MU is high). Now imagine that there is a market portfolio that has a return R which is perfectly negatively correlated with the marginal utility of the consumtion tomorrow ( ). This will give us the following implications ( ( ( ) ) ( ) ) ( ( ) ) ( )

So given we change the previous equation into, ( ) Now using E(R ) and E(X), E(X) ( ) ( ) ( ( ( ) ) ( )) ( ( ) ) ( ( )) ( ( )) ( ( ) ) ( ( ( ) ) ( )) ( ( ) ( ))

( ) E(R )

( ) ( ) Combining these two equations by multiplication, ( ) ( ) Recall that ( ( ) ) ( ( ( ( ( ) ) ) )

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

( ( )) ( ( ) )

( ) ( ( ))

), so the equation above can be simplified and presented as, ( ) ( ) ( ) ( ( ) ( ) ( ) ( ( ) ( ) ( ( ) ) ) )

( ) ( )

Thus giving the CAPM where the expected value of the asset is given by the risk free rate and the risk premium multiplied by the
( ) ( )

( )

( ( )

It is important to take note that the essential difference between the CAPM and CCAPM is the difference in beta. With regards to the CAPM, its beta reflects how a particular asset goes with the fluctuations in the market. On the other hand, the CCAPM takes into account the consumption under an intertemporal horizon.