Capital Asset Pricing Model

The capital asset pricing model was developed in mid-1960s by three researchers William Sharpe, John Lintner and Jan Mossin independently. Consequently, the model is often referred to as Sharpe-Lintner-Mosin Capital Asset Pricing Model.

The capital asset pricing model or CAPM is really an extension of the portfolio theory of Markowitz. The portfolio theory is a description of how rational investors should build efficient portfolio and select optimal portfolio. The capital asset pricing model derives the relationship between the expected return and the risk of the individual securities and portfolios in the capital markets if everyone behaved in the way of portfolio theory suggested.

The relationship between the risk and return established by the security market line is known as CAPM. Basically it’s a simple linear relationship. The higher the value of beta, higher would be the risk of the security. And therefore, larger would be the return expected buy the investor. In other words all securities are expected to yield returns commensurate with their riskiness as measured by beta. The relationship is not only valid for individual securities but it is also valid for all portfolios whether efficient or inefficient.

Assumptions

1. Investors make their investment decision on the basis of risk return assessment measured in terms of expected return and standard deviation of returns.
2. The purchase and sale of a security can be undertaken in infinitely divisible units.
3. Purchase and sales by a single investor cannot affect prices. This means there is prefect completion where investors in total determine prices by their action.
4. There is no transaction cost. Given the fact that the transaction cost is small. They are probably of minor importance in investment decisions. Hence they are ignored.
5. There are no personal income taxes.
6. The investor can lend or borrow any amount of funds desired at a rate of interest equal to the rate of riskless securities.
7. The investor can sell short any amount of any shares.
8. Investor shares homogeneity of expectations.