By Lars Tyge Nielsen and Maria Vassalou

Forthcoming in Economic Theory (2006)

Abstract

We show that if the intercept and slope of the instantaneous capital market line are deterministic, then investors will not hold any hedge portfolios in the sense of Merton [9, 1973], [11, 1990]. They will choose portfolios that plot on the capital market line, and they will slide up and down the capital market line over time as their wealth and risk tolerance change. This result allows us to aggregate over investors and derive a single factor CAPM where the first and second moments of security returns may change stochastically over time and markets are potentially incomplete.

JEL classification: G11, G12

Keywords: portfolio optimization, incomplete markets, capital market line, mutual fund separation