endogeneity of equilibrium return parameters and portfolio selection

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ENDOGENEITY OF EQUILIBRIUM RETURN PARAMETERS AND PORTFOLIO SELECTION
Koohyun Park1
Hongik University, Seoul, 121-791, Korea
Thomas Rhee
California State University, Long Beach, CA 90840-8501, USA
The paper presents a numerical procedure to compute various return parameters in portfolio selection
models. The approach assumes that joint return parameters in portfolio studies are not exogenous; and
are in fact determined within a system of general equilibrium in the capital market. This paper assumes
that derivatives exist for every underlying asset. In fact, we derive the equilibrium expected returns,
covariance-variance return parameters and even optimal portfolio weights for underlying securities from
the value of derivatives. To this end, we invoke the usual no arbitrage argument in the traditional
options literature without having to assume a priori about particular securities return distributions, e.g.
log-normalities; and hence, the derived return parameters are a simple martingale probability measure
of European call option prices. Consequently, we argue that all return parameters are "forward looking."
The paper then offers a new meaning to the equilibrium expected returns in the usual Capital Asset
Pricing Model (CAPM) when we solve a system of linear equations using this new approach of portfolio
selection.
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This research was conducted while Prof. Park was a visiting scholar in the 2014-15 Academic Year at the College of Business
Administration, California State University, Long Beach.
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