A Structural Model for Capital Asset Prices

Key Findings

Idiosyncratic risk affects asset prices profoundly in the CAPM. Historically, this conclusion was obscured by the assumption that MPT expected return and covariance parameters were known in equilibrium.

Abstract

Reframing modern portfolio theory with Gaussian cash flows rather than percentage returns, the CFPM (cash flow portfolio model) sets a structural foundation for valuing both traditional capital assets and derivatives. Asset prices are shown to be decreasing functions of both cash flow covariances and variances. The usual single-period CAPM formulas can be derived, but the expected returns are determined endogenously. All risk is implicitly priced in expected returns, leading to reinterpreted rules for portfolio selection and capital budgeting. Derivatives obey the same total covariance-based pricing relationships as cash flows, except that they exist in zero net supply. Together with a single no-arbitrage convexity constraint, the Bachelier and Black-Scholes/Merton option pricing models are derived in a discrete time setting without continuous trading. The closed-form CFPM extends to multiple periods. The resulting model aspires to replace multiperiod discounting of cash flows at constant single-period CAPM discount rates.