Capital asset pricing has always been an active area in the finance literature. The capitalasset pricing model (CAPM) of Sharpe (1964), Linter (1965) is a major analytical tool for explaining relationship between the expected return and risk. The competing model of CAPM is three-factor model of Fama and French (1993). Both are linear regression basedmodels used for the calculation of expected return.
Investment decisions are based on cost benefit analysis and risk rewardanalysis. The higher the risk in an investment, the higher will be the return.William Sharpe laid down the foundation of empirical asset pricing models. Theidea behind the Sharpe’s CAPM was that expected return on a security is the sumof risk free rate plus risk premium, where risk premium is the linear function(demonstrated by beta) of the co-variance between the excess return of thesecurity/portfolio and the excess return of the market (fully diversified) portfolio.The CAPM equation for the excess return is;(Ri-Rf) = a + b(Rm-Rf) + eWhere;(Ri) is the return of the security/portfolio.(Rf) is the risk free rate. (T-bill rate)(Rm) is the return of fully diversified portfolio.(b) is the slope or risk of the security.(e) is the error term.The CAPM Equation for the expected return is;E(Ri) = Rf + b(Rm-Rf) + eWhere;E(Ri) is the expected total return.(e) is the error term.In simple according to William Sharpe risk premium of security/portfoliois only related to the risk taken as compared to the market portfolio’s risk.