The Capital Asset Pricing Model (CAPM)
In almost every economics textbook (Ben and Robert, 2001), economists
tend to argue: everything’s market price is determined by consumers’
demand and supply in the market, the intersection of which gives us
the long-term concept of ‘market equilibrium’. Although it sounds
straightforward, it is anything but easy in practice, especially when
the assets (like common stock) you are measuring associated with risk
and future uncertainties. Fortunately, economists and financial
analysts have developed plenty of theories to help us explain how the
risk for market assets can be appropriately measured in our life.
Capital Asset Pricing Model (‘CAPM’) is one of the most influential
and applicable models, which give good explanations and predictions of
‘market price for risk’. This essay is going to look at what the CAPM
really is, how it is derived and used, and will also see some
limitations of applying it in practice.
First of all, we have to make some assumptions here, as the CAPM is
developed in a hypothetical world, as written in the theory of
business finance (Archer and Ambrosio, 1970):
* Investors are risk-averse individuals who maximize the expected
utility of their end-period wealth.
* Investors are price takers and have homogeneous expectations about
asset returns that have a joint normal distribution.
* There exists a risk-free asset such that investors may borrow or
lend unlimited amounts at the risk free rate.
* The quantities of assets are fixed. Also, all assets are
marketable and perfectly divisible.
* Asset markets are frictionless and information is costless and
simultaneously available to all investors.
* There are no market imperfections.
Although not all these assumptions conform to reality, they are
simplifications that permit the development of the CAPM.
Derivation of the CAPM
According to Financial theory and corporate policy (Copeland and
Weston, 1946), the CAPM is based on Harry Markowitz’s early portfolio
theory (1952) which showed how an investor can reduce the standard
deviation of portfolio returns by choosing stocks that do not move
exactly together (Brealey and Myers, 2003). Thereafter, William Sharpe
(1963) stimulated all possible combinations of stocks in the market,
getting a graph similar to Figure 1a below. Because of the one of the
golden rules in finance: ‘investors prefer higher return but low risk
(deviation)’, there must be some efficient portfolios that best
satisfies different investors’ preferences.
Here in figure 1b, all the points along the ‘efficient curve’ provide
investors with best return given certain risk level. It is a matter of
different preferences which are up to individuals’ different utility
function (Frank, 2003) and determine which to choose for different
investors. However, if an alternative investment opportunity is
introduced where investors...