The Capital Asset Pricing Model (CAPM) is an economic model for valuing
stocks, securities, derivatives and/or assets by relating risk and expected
return. CAPM is based on the idea that investors demand additional expected
return (called the risk premium) if they are asked to accept additional risk.
Description of CAPM. The Capital Asset Pricing Model is explained.
CAPM was introduced by Treynor ('61), Sharpe ('64) and Lintner ('65). By
introducing the notions of systematic and specific risk, it extended the portfolio
theory. In 1990, William Sharpe was Nobel price winner for Economics.
"For his contributions to the theory of price formation for financial assets,
the socalled Capital Asset Pricing Model (CAPM)."
The CAPM model says that the expected return that the investors will demand,
is equal to: the rate on a riskfree security plus a risk premium. If the
expected return is not equal to or higher than the required return, the investors
will refuse to invest and the investment should not be undertaken.
CAPM decomposes a portfolio's risk into systematic risk and specific
risk. Systematic risk is the risk of holding the market portfolio. When
the market moves, each individual asset is more or less affected. To the extent
that any asset participates in such general market moves, that asset entails
systematic risk. Specific risk is the risk which is unique for an individual
asset. It represents the component of an asset's return which is not correlated
with general market moves.
According to CAPM, the marketplace compensates investors for taking systematic
risk but not for taking specific risk. This is because specific risk can be
diversified away. When an investor holds the market portfolio, each individual
asset in that portfolio entails specific risk. But through diversification,
the investor's net exposure is just the systematic risk of the market portfolio.
CAPM formula
The CAPM formula is:
Expected Security Return = Riskless Return + Beta x (Expected Market Risk
Premium)
or:
r = Rf + Beta x (RM  Rf)
{ Another version of the formula is: rRf
= Beta x (RM  Rf) }
where:
 r is the expected
return rate on a security;
 Rf is the rate of a "riskfree"
investment, i.e. cash;
 RM is the return rate of the appropriate
asset class.
Beta is the overall risk in investing in a large market, like the New York
Stock Exchange. Beta, by definition equals 1,00000 exactly.
Each company also has a Beta. The Beta of a company is that company's risk
compared to the Beta (Risk) of the overall market. If the company has a Beta
of 3.0, then it is supposed to be 3 times more risky than the overall market.
Beta indicates the volatility of the security, relative to the asset class.
Investing in individual securities
A consequence of CAPM thinking is that it implies that investing in individual
stocks is useless, because one can duplicate the reward and risk characteristics
of any security just by using the right mix of cash with the appropriate asset
class. This is why diehard followers of CAPM avoid securities, and instead
build portfolios merely out of lowcost index funds.
Assumptions of the Capital Asset Pricing Model
Note! The Capital Asset Pricing Model is a ceteris paribus model. It is
only valid within a special set of assumptions. These are:
 Investors are risk averse individuals who maximize the expected utility
of their end of period wealth. Implication: The model is a one period model.
 Investors have homogenous expectations (beliefs) about asset returns.
Implication: all investors perceive identical opportunity sets. This means
everyone has the same information at the same time.
 Asset returns are distributed by the normal distribution.
 There exists a risk free asset and investors may borrow or lend unlimited
amounts of this asset at a constant rate: the risk free rate.
 There is a definite number of assets and their quantities are fixated
within the one period world.
 All assets are perfectly divisible and priced in a perfectly competitive
marked. Implication: e.g. human capital is nonexisting (it is not divisible
and it can't be owned as an asset).
 Asset markets are frictionless and information is costless and simultaneously
available to all investors. Implication: borrowing rate equals the lending
rate.
 There are no market imperfections such as taxes, regulations, or restrictions
on short selling.
Normally, all of the assumptions mentioned above are neither valid nor
fulfilled. However, CAPM anyway remains one of the most used investments models
to determine risk and return.
Book: William F.
Sharpe  Portfolio Theory and Capital Markets
Book: Harry M.
Markowitz  MeanVariance Analysis in Portfolio Choice and Capital Markets
Book: Mary Jackson
 Advanced modelling in finance using Excel and VBA
Special Interest Group

Join

Capital Asset Pricing Model Special Interest Group.
Special Interest Group (442 members)


Forum about Capital Asset Pricing Model.


The toprated topics about Capital Asset Pricing Model. Here you will find the most valuable ideas and practical suggestions.


Advanced insights about Capital Asset Pricing Model. Here you will find professional advices by experts.

Rethinking CAPM Valuation, DCF, Capital Cost William F. Sharpe, who developed the Capital Asset Pricing Model, recently announced that his pioneering work on the CAP (...)


Postmodern Portfolio Theory Portfolio Theory, Minimum Acceptable Return, Downside Risk, Minimum Acceptable Return Postmodern portfolio theory (PMPT) was invented originally to improve portfolio optimization and asset allocation. Howe (...)



Various sources of information regarding Capital Asset Pricing Model. Here you will find powerpoints, videos, news, etc. to use in your own lectures and workshops.

CAPM Models Comparing CAPM models Paper by Don (Tissu) U.A. Galagedera provides a review of the main features of asset pricing models. The review includes (...)


The Capital Asset Pricing Model Indepth: Derivation, Calculation, Usage and Results CAPM, Capital Asset Pricing Model, This presentation provides a detailed explanation of the CAPM and includes the following sections:
1. Introduction
2. (...)


Introduction to Capital Market Efficiency: Portfolio Theory and CAPM CAPM, Portfolio Theory, Efficient Markets Hypothesis, Risk and Expected Return, Investing, Financial Asset Valuation This presentation provides insights into capital market efficiency, portfolio theory and the CAPM, by explaining the bas (...)


Firm Size Effect Literature Overview Paper by Mathijs A. van Dijk reviews 25 years of research on the size effect in international equity returns. Since Banz (...)


Efficient Markets and Behavioral Financial Decision Making Behavioral Finance, Rational Decisionmaking, CAPM This presentation elaborates on financial decision making in our market place and includes the following sections:
1. I (...)


Interview Sharpe: Background CAPM Understanding Two Basic Elements behind CAPM Short interview with Nobel Prizewinning economist William Sharpe in which he explains 2 key notions behind his Capital (...)


Value Premium and CAPM Value Premium Analysis Eugene F. Kama and Kenneth R. French examine:
(i) how value premiums vary with firm size,
(ii) whether the CAPM expl (...)


Three Centuries of Asset Pricing History of Asset Pricing, MeanVariance Portfolio Optimisation, Equilibrium Analysis, No Arbitrage Arguments This paper charters the historical development of asset pricing and derivative valuation.
It illustrates how asset pric (...)


Giving Financial Advice on Dealing with Uncertainty Financial Services, Asset Management, Financial Investing Harry Markowitz gives short answers two questions:
1. (How) can financial advisors help participants deal with uncertai (...)


Portfolio Evaluation Portfolio Evaluation, Sharpe Ratio, Treynor Ratio, Jensen Alpha Investors invest in different securities like bonds, shares, debentures etc. In a bid to gain returns with calculated ri (...)


A Brief History of Downside Risk Measures Finance  Security Analysis and Portfolio Management  Investment Risk  Downside Risk Portfolio theory is the application of decisionmaking tools under risk to the problem of managing risky investment port (...)


CAPM, Downside CAPM and the Traditional Performance Measures CAPM, Downside CAPM, Performance Measurement Ever since Sharpe and Litner presented the Capital Asset Princing Model (CAPM), the model was extensively investigated b (...)


Interview W. Blake: Golden Rules of Investing Advanced Implementation of Investing William Blake gives 2 golden rules on investing:
1. Diversify.
2. Keep costs low.
One easy way to achieve that is by (...)


Introduction and Summary of Futures and Stop Loss Contracts Initial understanding of Futures and Stop Loss Contracts A derivative is a financial contract which derives its value from the performance of another entity such as an asset, in (...)



Automatically jump to further useful sources regarding Capital Asset Pricing Model.





News

Videos

Presentations

Books

More




Compare with: Real Options
 Credit Risk Management 
Plausibility Theory 
Operations Research 
Strategic Risk
Management 
Relative Value of Growth
 Cost of Equity 
Cost of Capital
Return to Management Hub: Decisionmaking & Valuation  Finance & Investing
More Management Methods, Models and Theory


Copy this into your study materials:
and add a hyperlink to:


Link to this knowledge center

Copy this HTML code to your web site:






