Consumption and Portfolio Rules

In this chapter we study the portfolio choices of risk-averse individuals. We assume that there are n-risky assets and one risk-free asset. From the Euler equation, we derive the equilibrium relation known as the Consumer Capital Asset Pricing Model (CCAPM). This relationship expresses the risk premium as a function of the negative correlation between consumption and expected return. From the CCAPM model, we derive the Security Market Line (SML). The SML allows unsystematic or diversifiable risk to be distinguished from systematic risk as measured by the \(\beta \) index. The assumptions of efficient markets and random walk dynamics of security prices are consistent with the SML and the absence of arbitrage. Finally, we analyze anomalies, including the puzzles of the equity premium and the risk-free rate.