Stock market indices are frequently used as local proxies for the market-and in that case (by definition) have a beta of one. market risk, the market as a whole, by definition, has a beta of one. Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. Given the accepted concave utility function, the CAPM is consistent with intuition-investors (should) require a higher return for holding a more risky asset. ![]() 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. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness.īetas exceeding one signify more than average "riskiness" betas below one indicate lower than average. The CAPM returns the asset-appropriate required return or discount rate-i.e. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:Į ( R i ) − R f β i = E ( R m ) − R f is the payoff of the asset or portfolio. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. For individual securities, we make use of 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 CAPM is a model for pricing an individual security or portfolio. This version was more robust against empirical testing and was influential in the widespread adoption of the CAPM. Fischer Black (1972) developed another version of CAPM, called Black CAPM or zero-beta CAPM, that does not assume the existence of a riskless asset. Sharpe, Markowitz and Merton Miller jointly received the 1990 Nobel Memorial Prize in Economics for this contribution to the field of financial economics. Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. The CAPM was introduced by Jack Treynor (1961, 1962), William F. Despite its failing numerous empirical tests, and the existence of more modern approaches to asset pricing and portfolio selection (such as arbitrage pricing theory and Merton's portfolio problem), the CAPM still remains popular due to its simplicity and utility in a variety of situations. Under these conditions, CAPM shows that the cost of equity capital is determined only by beta. CAPM assumes a particular form of utility functions (in which only first and second moments matter, that is risk is measured by variance, for example a quadratic utility) or alternatively asset returns whose probability distributions are completely described by the first two moments (for example, the normal distribution) and zero transaction costs (necessary for diversification to get rid of all idiosyncratic risk). The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. In finance, the capital asset pricing model ( CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. An estimation of the CAPM and the security market line (purple) for the Dow Jones Industrial Average over 3 years for monthly data.
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