Capital Asset Pricing Model

Origins: Risk and Returns

Since the beginning of Financial Economics, researchers have always seen a relation between risk and return. During the Midddle Age, boats travelling around the globe were already insured in function of the destination, the type of ship and the shipment.

But it was only after the 1950's that a clear relationship between risk and return had been established by Harry Markowitz with his works on the Portfolio theory.

Sharpe and Litner: CAPM

(See the article on Financial economics, paragraph 2.3, Equity pricing)

Assumptions of the CAPM

As all models, the CAPM need some simplifying assumptions. For many of them, it had later been demonstrated that they can be relaxed, at the cost of complexification.

• Investors, taken individually, are small compared to the market.It implies that they are price takers meaning that they can not influence prices.
• Investors are risk-averse
• Investors are myopics and only care about returns over one period.
• Investors have homogeneous expectations about returns and risk of financial assets, meaning, that they all use the same expected returns and covariance matrix.
• Investors all all mean-variance optimizers, what implies the use of the Portfolio Theory.
• Returns follow a normal distribution
• Asset markets are frictionless meaning that there are no transaction costs or taxes. Information is costless.
• Existence of a unique risk-free rate at which the investor can borrow or lend money.
• Inflation is fully anticipated.