Capital Asset Pricing Model

Capital Asset Pricing Model

The Capital Asset Pricing Model otherwise know as CAPM defines the relationship between risk and return for individual securities. William Sharpe published the capital asset pricing model in 1964. CAPM extended Harry Markowitz's portfolio theory to introduce the notions of systematic and specific risk. For his work on CAPM, Sharpe shared the 1990 Nobel Prize in Economics with Harry Markowitz and Merton Miller

CAPM assumes the concept of a logical investor, assumes a perfect market, and uses a measure of investment risk known as a Beta. When CAPM assumes these three concepts above there has to be a definition to describe the assumptions.

Therefore when we assume a logical investor we are actually referring to an investor that makes his or her investments based upon the expectation of a return. Investors will anticipate their return by analyzing the stock market’s average rate of return and that will be their expectation when looking into a specific security. If they are not going to anticipate their return to equal the markets average rate of return then there will be no reason to invest. You invest to make a profit. Investors invest to make a profit. Furthermore a logical investor accepts the market rate of risk. Since they are anticipating the average market rate of return they also have to be willing to accept the market rate of risk. Logical investors might be willing to take on a greater rate of risk than the average market rate of risk but, in doing so they will be required to be rewarded or compensated with a higher rate of return from that more risky investment. So, on the flip side if a logical investor invested in a security with a lower rate of risk than the market average they would have to assume and understand that their return will also be lower than the average market rate of return. More risk, more money. Lower risk, less money.

Assuming a perfect market in CAPM (if there is such a thing) takes these key concepts into consideration. The market is open to anyone who would like to invest into it. There are no organizations or significant obstacles to prevent the average Joe or Jane from entering into it. It is not primarily run by one company or one large investor. There is a sufficient availability of securities present priced at a risk less rate to which any investor can borrow or lend. There are no obstacles preventing free trade such as taxes, memberships, dealing charges, etc. The perfect market is aware to all pertinent information relating to every security that is readily available for purchase to a logical investor. All investors have homogeneous expectations from the market. Finally, all investors have homogeneous perceptions of every readily available security or fund available for purchase.

Beta measurement requires the acknowledgement of two points for which are specifically defined. First point is defined as a rate of return for risk-free investments. This rate of risk is given a Beta value of 0. Government Treasury Bills (particularly US Government ones) are often cited as risk-free investments with a Beta value of 0. The second point is defined as a rate of return for investments carrying the market rate of risk (i.e. the rate of Market Risk). This rate of risk is given a Beta value of 1. With that well defined and well understood a security with a Beta value of 0.6 is assumed to be more risky than a risk-free investment, but only 60% as risky as an investment carrying the market rate of risk. Another security, with a Beta value of 3.5 is assumed to be three-and-a-half times as risky as an investment carrying the market rate of risk. It is theoretically