Abstract

An intertemporal model for the capital market is deduced from the portfolio selection behavior by an arbitrary number of investors who act so as to maximize the expected utility of lifetime consumption and who can trade continuously in time. Explicit demand functions for assets are derived, and it is shown that, unlike the one-period model, current demands are affected by the possibility of uncertain changes in future investment opportunities. After aggregating demands and requiring market clearing, the equilibrium relationships among expected returns are derived, and contrary to the classical capital asset pricing model, expected returns on risky assets may differ from the riskless rate even when they have no systematic or market risk.

Scientific Portfolio AI- Generated Summary

Robert C. Merton’s paper “An Intertemporal Capital Asset Pricing Model” presents a new approach to portfolio selection and market equilibrium that challenges traditional assumptions about risk and return. The paper argues that investors should not only consider the expected returns and variances of assets in the current period, but also the expected returns and variances of assets in future periods. This intertemporal perspective leads to a new set of testable hypotheses about asset prices and portfolio selection.

Merton’s model assumes that investors have a utility function that depends on consumption in each period, and that they face uncertainty about future investment opportunities. The model shows that the optimal portfolio for an investor depends on their expectations about future investment opportunities, as well as their current wealth and consumption needs. In particular, the model predicts that investors will demand more of assets that have high expected returns in periods when investment opportunities are expected to be good, and less of assets that have high expected returns in periods when investment opportunities are expected to be bad.

The paper also shows that the intertemporal model can explain several empirical puzzles that are not easily explained by the classical capital asset pricing model. For example, the model can explain why long-term bonds often have higher yields than short-term bonds, even though they are both considered to be relatively safe assets. The model predicts that long-term bonds will have higher yields when investment opportunities are expected to be good in the future, because investors will demand compensation for the risk of missing out on those opportunities.

Merton’s model has important implications for portfolio selection and asset pricing. The model suggests that investors should not only consider the expected returns and variances of assets in the current period, but also the expected returns and variances of assets in future periods. This intertemporal perspective can lead to different optimal portfolios than those suggested by the classical model. The model also suggests that asset prices should reflect investors’ expectations about future investment opportunities, and that these expectations can change over time in response to new information.

Overall, Merton’s intertemporal capital asset pricing model is a groundbreaking contribution to the field of finance. The model challenges traditional assumptions about risk and return, and provides a new framework for understanding portfolio selection and market equilibrium. The model has important implications for investors, asset managers, and policymakers, and has inspired a large body of research in finance and economics.