Basics of the Capital Asset

Pricing Model
The Capital Asset Pricing Model (CAPM) is the most popular
model of the determination of expected returns on securities
and other financial assets. It is considered to be an asset
pricing model since, for a given exogenous expected payoff,
the asset price can be backed out once the expected return is
determined
DERIVATION AND INTERPRETATION
OF THE CAPM PRICING FORMULA
Algebra of the Portfolio Frontier:
(b) The Capital Asset Pricing Model and Its
Assumptions

The investor-specific result of equations (7) and (8) required the

following assumptions, categorized by the part of the decision problem
that requires the assumption:

Objectives

1. Investor preferences display risk aversion and non-satiation, and

are quadratic; or, if preferences are not quadratic, asset returns are
multi-variate elliptically distributed.
2. One-period model.

3. Only total consumption matters.

4. Perfect competition.

5. Absence of frictions

6. All assets owned by the investor are marketable

7. Information on any asset, if available, can be

obtained without cost
8. The types of assets are given exogenously.

9. Assets are perfectly divisible.

10. A riskless asset exists.

11. Homogeneous availability and interpretation

of information.

12. Homogeneous access to investment

opportunities.
13. Market clearing.
(c) Interpretation of the CAPM formula
Yet a third way to interpret risk in the CAPM, yielding a similar
decomposition, considers the marginal impact of asset i in affecting total
portfolio risk, as measured by variance. First, using the linearity property of
covariance as derived in the Appendix together with the expression of
market portfolio return as a weighted average of asset returns, write
portfolio variance as:

Again similar but not quite identical to the two earlier interpretations of
risk.
(d) Some Empirical Issues
In empirical work it is standard to use a U.S. stock market index as the market
portfolio. The CAPM is then tested via a two-pass regression. First, the beta is
estimated from a time series regression by regressing past asset returns on
past market returns, typically using five years of monthly data. The beta is
found as the slope coefficient of the regression [as follows from equation (9)]:
Figure 3 illustrates the empirical SML in the case when the realized
excess market return is negative.
(e) Applications of Beta Estimation and the CAPM

The applications of the CAPM can be categorized in the following

groups:

1. The Cost of Capital

2. Portfolio Return Evaluation

3. Event Studies