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Security Market Line (purple) Ior the

Dow Jones Industrial Average over the

last 3 years Ior monthly data.

From Wikipedia, the Iree encyclopedia

In Iinance, the capital asset pricing model (CAPM) is used to

determine a theoretically appropriate required rate oI return oI an asset,

iI that asset is to be added to an already well-diversiIied portIolio, given

that asset's non-diversiIiable risk. The model takes into account the

asset's sensitivity to non-diversiIiable risk (also known as systematic risk

or market risk), oIten represented by the quantity beta () in the

Iinancial industry, as well as the expected return oI the market and the

expected return oI a theoretical risk-Iree asset.

The model was introduced by Jack Treynor (1961, 1962),

|1|

William

Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966)

independently, building on the earlier work oI Harry Markowitz on

diversiIication and modern portIolio theory. Sharpe, Markowitz and

Merton Miller jointly received the Nobel Memorial Prize in Economics

Ior this contribution to the Iield oI Iinancial economics.

Contents

1 The Iormula

2 Security market line

3 Asset pricing

4 Asset-speciIic required return

5 Risk and diversiIication

6 The eIIicient Irontier

7 The market portIolio

8 Assumptions oI CAPM

9 Shortcomings oI CAPM

10 See also

11 ReIerences

12 Bibliography

13 External links

The formula

Capital asset pricing model - Wikipedia, the Iree encyclopedia http://en.wikipedia.org/wiki/Capitalassetpricingmodel

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The Security Market Line, seen here in a graph, describes a

relation between the beta and the asset's expected rate oI

return.

The CAPM is a model Ior pricing an individual security

or a portIolio. For individual securities, we make use oI

the security market line (SML) and its relation to

expected return and systematic risk (beta) to show how

the market must price individual securities in relation to

their security risk class. The SML enables us to calculate

the reward-to-risk ratio Ior any security in relation to

that oI the overall market. ThereIore, when the expected

rate oI return Ior any security is deIlated by its beta

coeIIicient, the reward-to-risk ratio Ior any individual

security in the market is equal to the market reward-

to-risk ratio, thus:

The market reward-to-risk ratio is eIIectively the market risk premium and by rearranging the above equation

and solving Ior E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

where:

is the expected excess return on the capital asset

is the risk-Iree rate oI interest such as interest arising Irom government bonds

(the beta coefficient) is the sensitivity oI the expected excess asset returns to the expected excess

market returns, or also ,

is the expected excess return oI the market

is sometimes known as the market premium or risk premium (the diIIerence between the

expected market rate oI return and the risk-Iree rate oI return).

Restated, in terms oI risk premium, we Iind that:

which states that the individual risk premium equals the market premium times .

Note 1: the expected market rate oI return is usually estimated by measuring the Geometric Average oI the

historical returns on a market portIolio (i.e. S&P 500).

Note 2: the risk Iree rate oI return used Ior determining the risk premium is usually the arithmetic average oI

historical risk Iree rates oI return and not the current risk Iree rate oI return.

For the Iull derivation see Modern portIolio theory.

Security market line

The SML essentially graphs the results Irom the capital asset pricing model (CAPM) Iormula. The x-axis

Capital asset pricing model - Wikipedia, the Iree encyclopedia http://en.wikipedia.org/wiki/Capitalassetpricingmodel

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represents the risk (beta), and the v-axis represents the expected return. The market risk premium is determined

Irom the slope oI the SML.

The relationship between and required return is plotted on the securities market line (SML) which shows

expected return as a Iunction oI . The intercept is the nominal risk-Iree rate available Ior the market, while the

slope is E(R

m

R

f

). The securities market line can be regarded as representing a single-Iactor model oI the asset

price, where Beta is exposure to changes in value oI the Market. The equation oI the SML is thus:

It is a useIul tool in determining iI an asset being considered Ior a portIolio oIIers a reasonable expected return

Ior risk. Individual securities are plotted on the SML graph. II the security's risk versus expected return is

plotted above the SML, it is undervalued since the investor can expect a greater return Ior the inherent risk. And

a security plotted below the SML is overvalued since the investor would be accepting less return Ior the amount

oI risk assumed.

Asset pricing

Once the expected/required rate oI return, E(R

i

), is calculated using CAPM, we can compare this required rate

oI return to the asset's estimated rate oI return over a speciIic investment horizon to determine whether it would

be an appropriate investment. To make this comparison, you need an independent estimate oI the return outlook

Ior the security based on either fundamental or technical analysis techniques, including P/E, M/B etc.

In theory, thereIore, an asset is correctly priced when its estimated price is the same as the required rates oI

return calculated using the CAPM. II the estimate price is higher than the CAPM valuation, then the asset is

undervalued (and overvalued when the estimated price is below the CAPM valuation).

Asset-specific required return

The CAPM returns the asset-appropriate required return or discount rate - i.e. the rate at which Iuture cash

Ilows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one

signiIy more than average "riskiness"; betas below one indicate lower than average. Thus a more risky stock will

have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be

discounted at a lower rate. Given the accepted concave utility Iunction, the CAPM is consistent with intuition -

investors (should) require a higher return Ior holding a more risky asset.

Since beta reIlects asset-speciIic sensitivity to non-diversiIiable, i.e. market risk, the market as a whole, by

deIinition, has a beta oI one. Stock market indices are Irequently used as local proxies Ior the market - and in

that case (by deIinition) have a beta oI one. An investor in a large, diversiIied portIolio (such as a mutual Iund)

thereIore expects perIormance in line with the market.

Risk and diversification

The risk oI a portIolio comprises systematic risk, also known as undiversiIiable risk, and unsystematic risk which

is also known as idiosyncratic risk or diversiIiable risk. Systematic risk reIers to the risk common to all securities

- i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be

diversiIied away to smaller levels by including a greater number oI assets in the portIolio (speciIic risks "average

Capital asset pricing model - Wikipedia, the Iree encyclopedia http://en.wikipedia.org/wiki/Capitalassetpricingmodel

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The (Markowitz) eIIicient Irontier. CAL stands Ior the capital allocation line.

out"). The same is not possible Ior systematic risk within one market. Depending on the market, a portIolio oI

approximately 30-40 securities in developed markets such as UK or US will render the portIolio suIIiciently

diversiIied such that risk exposure is limited to systematic risk only. In developing markets a larger number is

required, due to the higher asset volatilities.

A rational investor should not take on any diversiIiable risk, as only non-diversiIiable risks are rewarded within

the scope oI this model. ThereIore, the required return on an asset, that is, the return that compensates Ior risk

taken, must be linked to its riskiness in a portIolio context - i.e. its contribution to overall portIolio riskiness - as

opposed to its "stand alone riskiness." In the CAPM context, portIolio risk is represented by higher variance i.e.

less predictability. In other words the beta oI the portIolio is the deIining Iactor in rewarding the systematic

exposure taken by an investor.

The efficient frontier

Main article. Efficient frontier

The CAPM assumes that the

risk-return proIile oI a portIolio can be

optimized - an optimal portIolio

displays the lowest possible level oI

risk Ior its level oI return. Additionally,

since each additional asset introduced

into a portIolio Iurther diversiIies the

portIolio, the optimal portIolio must

comprise every asset, (assuming no

trading costs) with each asset value-

weighted to achieve the above

(assuming that any asset is inIinitely

divisible). All such optimal portIolios,

i.e., one Ior each level oI return,

comprise the eIIicient Irontier.

Because the unsystematic risk is diversiIiable, the total risk oI a portIolio can be viewed as beta.

The market portfolio

An investor might choose to invest a proportion oI his or her wealth in a portIolio oI risky assets with the

remainder in cash - earning interest at the risk Iree rate (or indeed may borrow money to Iund his or her

purchase oI risky assets in which case there is a negative cash weighting). Here, the ratio oI risky assets to risk

Iree asset does not determine overall return - this relationship is clearly linear. It is thus possible to achieve a

particular return in one oI two ways:

By investing all oI one's wealth in a risky portIolio, 1.

or by investing a proportion in a risky portIolio and the remainder in cash (either borrowed or invested). 2.

For a given level oI return, however, only one oI these portIolios will be optimal (in the sense oI lowest risk).

Since the risk Iree asset is, by deIinition, uncorrelated with any other asset, option 2 will generally have the

lower variance and hence be the more eIIicient oI the two.

Capital asset pricing model - Wikipedia, the Iree encyclopedia http://en.wikipedia.org/wiki/Capitalassetpricingmodel

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This relationship also holds Ior portIolios along the eIIicient Irontier: a higher return portIolio plus cash is more

eIIicient than a lower return portIolio alone Ior that lower level oI return. For a given risk Iree rate, there is only

one optimal portIolio which can be combined with cash to achieve the lowest level oI risk Ior any possible

return. This is the market portIolio.

Assumptions of CAPM

All investors:

Aim to maximize economic utility. 1.

Are rational and risk-averse. 2.

Are broadly diversiIied across a range oI investments. 3.

Are price takers, i.e., they cannot inIluence prices. 4.

Can lend and borrow unlimited under the risk Iree rate oI interest. 5.

Trade without transaction or taxation costs. 6.

Deal with securities that are all highly divisible into small parcels. 7.

Assume all inIormation is at the same time available to all investors. 8.

PerIect Competitive Markets 9.

Shortcomings of CAPM

The model assumes that either asset returns are (jointly) normally distributed random variables or that

investors employ a quadratic Iorm oI utility. It is however Irequently observed that returns in equity and

other markets are not normally distributed. As a result, large swings (3 to 6 standard deviations Irom the

mean) occur in the market more Irequently than the normal distribution assumption would expect.

|2|

The model assumes that the variance oI returns is an adequate measurement oI risk. This might be

justiIied under the assumption oI normally distributed returns, but Ior general return distributions other

risk measures (like coherent risk measures) will likely reIlect the investors' preIerences more adequately.

Indeed risk in Iinancial investments is not variance in itselI, rather it is the probability oI losing: it is

asymmetric in nature.

The model assumes that all investors have access to the same inIormation and agree about the risk and

expected return oI all assets (homogeneous expectations assumption).

|citation needed|

The model assumes that the probability belieIs oI investors match the true distribution oI returns. A

diIIerent possibility is that investors' expectations are biased, causing market prices to be inIormationally

ineIIicient. This possibility is studied in the Iield oI behavioral Iinance, which uses psychological

assumptions to provide alternatives to the CAPM such as the overconIidence-based asset pricing model oI

Kent Daniel, David HirshleiIer, and Avanidhar Subrahmanyam (2001)

|3|

.

The model does not appear to adequately explain the variation in stock returns. Empirical studies show

that low beta stocks may oIIer higher returns than the model would predict. Some data to this eIIect was

presented as early as a 1969 conIerence in BuIIalo, New York in a paper by Fischer Black, Michael

Jensen, and Myron Scholes. Either that Iact is itselI rational (which saves the eIIicient-market hypothesis

but makes CAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong indeed, this

possibility makes volatility arbitrage a strategy Ior reliably beating the market).

|citation needed|

The model assumes that given a certain expected return investors will preIer lower risk (lower variance)

to higher risk and conversely given a certain level oI risk will preIer higher returns to lower ones. It does

not allow Ior investors who will accept lower returns Ior higher risk. Casino gamblers clearly pay Ior risk,

and it is possible that some stock traders will pay Ior risk as well.

|citation needed|

The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed

Capital asset pricing model - Wikipedia, the Iree encyclopedia http://en.wikipedia.org/wiki/Capitalassetpricingmodel

5 oI 7 2/20/2010 4:53 PM

with more complicated versions oI the model.

|citation needed|

The market portIolio consists oI all assets in all markets, where each asset is weighted by its market

capitalization. This assumes no preIerence between markets and assets Ior individual investors, and that

investors choose assets solely as a Iunction oI their risk-return proIile. It also assumes that all assets are

inIinitely divisible as to the amount which may be held or transacted.

|citation needed|

The market portIolio should in theory include all types oI assets that are held by anyone as an investment

(including works oI art, real estate, human capital...) In practice, such a market portIolio is unobservable

and people usually substitute a stock index as a proxy Ior the true market portIolio. UnIortunately, it has

been shown that this substitution is not innocuous and can lead to Ialse inIerences as to the validity oI the

CAPM, and it has been said that due to the inobservability oI the true market portIolio, the CAPM might

not be empirically testable. This was presented in greater depth in a paper by Richard Roll in 1977, and is

generally reIerred to as Roll's critique.

|4|

The model assumes just two dates, so that there is no opportunity to consume and rebalance portIolios

repeatedly over time. The basic insights oI the model are extended and generalized in the intertemporal

CAPM (ICAPM) oI Robert Merton, and the consumption CAPM (CCAPM) oI Douglas Breeden and

Mark Rubinstein.

|citation needed|

CAPM assumes that all investors will consider all oI their assets and optimize one portIolio. This is in

sharp contradiction with portIolios that are held by investors: humans tend to have Iragmented portIolios

(or rather multiple portIolios: Ior each goal one portIolio - see behavioural portIolio theory

|5|

and

Maslowian PortIolio Theory

|6|

.

See also

Arbitrage pricing theory (APT)

Consumption beta (C-CAPM)

EIIicient market hypothesis

Fama-French three-Iactor model

Hamada's equation

Modern portIolio theory

Roll's critique

Valuation (Iinance)

References

^ http://ssrn.com/abstract447580 1.

^ Mandelbrot, B., and Hudson, R. L. (2004). The (Mis)Behaviour oI Markets: A Fractal View oI Risk, Ruin, and

Reward. London: ProIile Books.

2.

^ 'OverconIidence, Arbitrage, and Equilibrium Asset Pricing,' Kent D. Daniel, David HirshleiIer and Avanidhar

Subrahmanyam, Journal oI Finance, 56(3) (June, 2001), pp. 921-965

3.

^ 'ROLL, R. (1977): 'A Critique oI the Asset Pricing Theory`s Tests, Journal oI Financial Economics, 4, 129176. 4.

^ SHEFRIN, H., AND M. STATMAN (2000): 'Behavioral PortIolio Theory, Journal oI Financial and Quantitative

Analysis, 35(2), 127151.

5.

^ DE BROUWER, Ph. (2009): 'Maslowian PortIolio Theory: An alternative Iormulation oI the Behavioural

PortIolio Theory, Journal oI Asset Management, 9 (6), pp. 359365.

6.

Capital asset pricing model - Wikipedia, the Iree encyclopedia http://en.wikipedia.org/wiki/Capitalassetpricingmodel

6 oI 7 2/20/2010 4:53 PM

This page was last modiIied on 19 February 2010 at 07:41.

Text is available under the Creative Commons Attribution-ShareAlike License; additional terms may

apply. See Terms oI Use Ior details.

Wikipedia is a registered trademark oI the Wikimedia Foundation, Inc., a non-proIit organization.

Bibliography

Black, Fischer., Michael C. Jensen, and Myron Scholes (1972). The Capital Asset Pricing Model. Some

Empirical Tests, pp. 79-121 in M. Jensen ed., Studies in the Theory oI Capital Markets. New York:

Praeger Publishers.

Fama, Eugene F. (1968). Risk, Return and Equilibrium. Some Clarifving Comments. Journal oI Finance

Vol. 23, No. 1, pp. 29-40.

Fama, Eugene F. and Kenneth French (1992). The Cross-Section of Expected Stock Returns. Journal oI

Finance, June 1992, 427-466.

French, Craig W. (2003). The Trevnor Capital Asset Pricing Model, Journal oI Investment Management,

Vol. 1, No. 2, pp. 60-72. Available at http://www.joim.com/

French, Craig W. (2002). Jack Trevnors Toward a Theorv of Market Jalue of Riskv Assets (December).

Available at http://ssrn.com/abstract628187

Lintner, John (1965). The valuation of risk assets and the selection of riskv investments in stock

portfolios and capital budgets, Review oI Economics and Statistics, 47 (1), 13-37.

Markowitz, Harry M. (1999). The earlv historv of portfolio theorv. 1600-1960, Financial Analysts

Journal, Vol. 55, No. 4

Mehrling, Perry (2005). Fischer Black and the Revolutionary Idea oI Finance. Hoboken: John Wiley &

Sons, Inc.

Mossin, Jan. (1966). Equilibrium in a Capital Asset Market, Econometrica, Vol. 34, No. 4, pp. 768-783.

Ross, Stephen A. (1977). The Capital Asset Pricing Model (CAPM), Short-sale Restrictions and Related

Issues, Journal oI Finance, 32 (177)

Rubinstein, Mark (2006). A History oI the Theory oI Investments. Hoboken: John Wiley & Sons, Inc.

Sharpe, William F. (1964). Capital asset prices. A theorv of market equilibrium under conditions of risk,

Journal oI Finance, 19 (3), 425-442

Stone, Bernell K. (1970) Risk, Return, and Equilibrium: A General Single-Period Theory oI Asset

Selection and Capital-Market Equilibrium. Cambridge: MIT Press.

Tobin, James (1958). Liquiditv preference as behavior towards risk, The Review oI Economic Studies,

25

Treynor, Jack L. (1961). Market Jalue, Time, and Risk. Unpublished manuscript.

Treynor, Jack L. (1962). Toward a Theorv of Market Jalue of Riskv Assets. Unpublished manuscript. A

Iinal version was published in 1999, in Asset Pricing and PortIolio PerIormance: Models, Strategy and

PerIormance Metrics. Robert A. Korajczyk (editor) London: Risk Books, pp. 15-22.

Mullins, David W. (1982). Does the capital asset pricing model work?, Harvard Business Review,

January-February 1982, 105-113.

External links

Two asset eIIicient Irontier (http://www.duke.edu/~charvey/twoasset/index.html)

Multiasset eIIicient Irontier (http://www.duke.edu/~charvey/Irontier/Irontier.html)

Retrieved Irom "http://en.wikipedia.org/wiki/Capitalassetpricingmodel"

Categories: Finance theories , Mathematical Iinance , Financial markets , PortIolio theories

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