An Asset–Liability Version of the Capital Asset Pricing Model with a Multi-Period Two-Fund Theorem

Abstract

Despite the simplicity of its strategic asset allocation policy prescription, the original Two-Fund Theorem has never been used by practitioners. The authors present a new capital asset pricing model (CAPM) that incorporates investors’ deferred spending plans, or “economic liabilities”—the underlying purpose behind all investments—and thus reveal a new risk-free asset, the investor’s liability-matching asset portfolio. In combination with a slightly redefined world market portfolio of risky assets, the authors’ model forms a new two-fund theorem that is sensible, practical, and usable. The revised theorem provides an accessible and tractable form of an intertemporal CAPM, bridging the large gap between the simplistic single-period CAPM of Sharpe and others and the difficult, complex intertemporal models of Merton and others.