The capital asset pricing model


Capital-asset pricing model (CAPM):

A model that describes the relationship between risk and expected (required) return; in this model, a security’s expected (required) return is the risk free rate plus a premium based on the systematic risk of the security.

Based on the behavior of risk-averse investors, there is an implied equilibrium relationship between risk and expected return for each security. In market equilibrium, a security is supposed to provide an expected return commensurate with its systematic risk—the risk that cannot be avoided by diversification. The greater the systematic risk of security, the greater the return that investors will expect from the security. The relationship between expected return and systematic risk, and the valuation of securities that follows, is the essence of Nobel laureate William Sharpe’s capital-asset pricing model (CAPM).

CAPM was developed in the 1960s, and it has had important implications for finance ever since. Though other models also attempt to capture market behavior, the CAPM is simple in concept and has real-world applicability.

Like any model, this one is a simplification of reality. Nevertheless, it allows us to draw certain implications about risk and the size of the risk premium necessary to compensate for bearing risk. In this article we are focusing on the general aspects of the model and its important implications. Certain corners have been cut in the interest of simplicity.

There are assumptions to be made and they are,

* Capital markets are efficient
* Investors are well informed
* Transactions costs are low
* There are negligible restrictions on investment
* No investor is large enough to affect the market price of a stock.

We also assume that investors are in general agreement about the likely performance of individual securities and their expectations are based on a common holding period, say, one year..

There are two types of investment opportunities with which we will be concerned. The first is a risk-free security whose return over the holding period is known with certainty. Frequently, the rate on short-to intermediate-term Treasury securities is used as a surrogate for the risk-free rate. The second is the market portfolio of common stocks. It is represented by all available common stocks and weighted according to their total aggregate market values outstanding.

Market portfolio is a some what unwieldy thing, to work, most people use a surrogate, such as the Standard & Poor’s 500 Stock Price Index (S&P 500 Index). This broad-based, market-value-weighted index reflects the performance of 500 major common stocks.

In conclusion we would like to infer that the risk cannot be avoided by efficient diversification because one cannot hold a more diversified portfolio than the market portfolio. It represents the limit to attainable diversification. Thus, all the risk associated with the market portfolio is unavoidable. Our introductory paragraph is self explanatory of the subject and our brief conclusion makes even a non-specialist understand this topic clearly.

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