Capital asset pricing model
Capital Asset Pricing Model (commonly referred to as CAPM) was introduced by William Sharpe[?], Lintner and Mossin independently, though it is commonly attributed only to the first of them, who published it earliest (in 1964), and subsequently received (jointly with Harry Markowitz[?] and Merton Miller[?]) the The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel for his contribution to the field of financial economics.
The risk of a portfolio is comprised of systematic risk[?] and specific risk[?]. Specific risk is the risk associated with individual assets. Systematic risk refers to the risk common to all securities. CAPM considers the market portfolio[?] (the value-weighted portfolio comprising every asset) as the optimal portfolio. The beta of a stock or a portfolio (e.g. mutual fund) measures its sensitivity to the movement of the broader market. Betas exceeding one signify more than average riskiness, stock market index has a beta of one. Most of mutual funds portfolios have systematic risk smaller than one.
According to the CAPM a the required rate of return of a stock is derived by:
where:
Does not edequately explain the variation in stock returns. Market portfolio and its return are unobservable and have to be estimated, therefore the model is not testable.
rs = β ( rm - rf ) + rf
rs is the required rate of return on a stock
rm is the market rate of return
rf is the risk free interest rate
β is the beta of the stock
Shortcomings of CAPM