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Capitsl Asset Pricing Modelf - Essay Example
Author : sporerchelsea
Pages 10 (2510 words)
Capital asset pricing model (CAPM) was first widely introduced in a fundamental work of William Sharpe (1964). It was presented as an extension of Markowitz's (1952) portfolio theory, according to which investors should consider overall risk-return rates of a portfolio instead of constructing portfolio from securities with best individual risk-return characteristics…
It was found that under these assumptions Tobin's (1958) super efficient portfolio (it consists of the risk-free asset added to Markowitz's portfolio on the efficient frontier) must also be market portfolio.
Further on, Sharpe (1964) divided portfolio risk into systematic and specific. While systematic risk affects every asset of a portfolio (as the market moves, each individual asset is more or less affected), specific risks are unique to individual assets (it represents the component of an asset's return which is uncorrelated with general market moves) and thus can be diversified in the context of a whole portfolio. In other words, the expected rate of return of a portfolio depends not on specific risks of assets, but on the systematic risk of a portfolio.
where ERi is the expected rate of return on asset i, Rf is a risk-free rate, ERm is the expected rate of return of the market portfolio, and is systematic risk. As can be seen from the SML equation, excess return depends on beta alone and not on systematic risk plus specific risk. Moreover, the connection between rate of return and beta is linear for portfolios.
Obviously, CAPM was designed as a way to determine prices of assets in market portfolios. ...