Write short notes on the following: a) Capital asset pricing model b) Permanent income hypothesis

a) Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a widely used financial model that explains how assets should be priced based on their risk. It shows the relationship between the expected return of an asset and its risk compared to the overall market.

Key Equation:

E(R_i) = R_f + β_i(R_m – R_f)

• E(R_i) = Expected return of the asset
• R_f = Risk-free rate (e.g., government bond)
• β_i = Beta of the asset (a measure of risk relative to the market)
• R_m = Expected return of the market

Explanation:

• The CAPM states that the return an investor expects from a stock depends on how much risk that stock adds to a diversified portfolio.
• Risk is measured by Beta. If β = 1, the asset moves with the market; if β > 1, it’s more volatile; if β < 1, it’s less volatile.

Implications:

• Helps investors calculate the fair return on an asset given its risk.
• Used to value stocks, make investment decisions, and evaluate portfolio performance.
• Supports the idea that only systematic risk matters; unsystematic risk can be diversified away.

Limitations:

• Assumes investors can borrow/lend at the risk-free rate.
• Relies on historical data to calculate Beta.
• Real markets have frictions (like taxes, transaction costs) that CAPM ignores.

b) Permanent Income Hypothesis (PIH)

The Permanent Income Hypothesis was developed by economist Milton Friedman. It explains how people decide how much to consume and save, based on their expectations of long-term income rather than current income.

Core Idea:

• People base consumption on their permanent income — the average income they expect over the long run — rather than their current or temporary income.
• Temporary changes in income do not significantly affect consumption because people save or borrow to smooth their consumption over time.

Formula:

C = αY_p

• C = Consumption
• Y_p = Permanent income
• α = Propensity to consume out of permanent income

Example:

• If a worker gets a temporary bonus, they may save most of it instead of increasing their regular spending.
• But if they get a permanent salary raise, they are more likely to increase long-term consumption (buy a house, car, etc.).

Implications:

• Helps explain why consumption is stable even when income is volatile.
• Challenges Keynesian consumption theory, which assumes people consume based on current income.
• Supports the idea that fiscal policies like temporary tax cuts may have limited effects on consumption.

Limitations:

• Assumes people are forward-looking and can predict future income accurately.
• Ignores liquidity constraints — not everyone can borrow during low-income periods.

Conclusion

Both CAPM and PIH have significantly influenced economics and finance. CAPM helps investors evaluate risk and expected returns, while PIH provides insights into consumer behavior and savings patterns. Though both have limitations, they remain foundational tools in macroeconomic and financial analysis.