The Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) was developed on the foundations of Markowitz (1952). Markowitz found that when two risky assets (measured through standard deviation) are combined, their standard deviations are not simply added providing the returns are not perfectly positively correlated. His studies can be used to generate an efficient frontier of portfolios; investors are now able to select a portfolio, which is most appropriate for them from the efficient set of portfolios.

“Sharpe (1964) developed a computationally efficient method, the single index model, where the return on an individual security is related to the return on a common index”(Galagedera, 2007, p821). “The CAPM is a theory originally devised by Sharpe (1964) to explain how the capital market sets share prices”(Neale, 2003, p332). Under the CAPM it is thought to be illogical for investors to have a portfolio that isn’t fully diversified.

The CAPM assumes, as does the portfolio theory that such portfolios eradicate any company specific risk (unsystematic risk). The remaining risk, which cannot be diversified, is called systematic risk. Systematic risk is common to all organisations to some degree. “A central tenet of the CAPM is that systematic risk, as measured by beta, is the only factor affecting the level of return required on a share for a completely diversified investor”(Arnold, 2005, p330). The CAPM shows how this risk factor of an investment moves with the market.

An important aspect to the CAPM is that the betas can be plotted against expected-returns to create the security market line (SML), which is a linear line to describe their relationship. This is why the CAPM was so important to the finance community. The CAPM has; changed the way portfolios are constructed, strengthened the belief that the stock exchange correctly prices shares, and changed the investment strategies of many investors as-well as changing the cost of capital calculation for organisations wishing to calculate the required rate of return of an investment.

Despite this CAPM has come under much scrutiny over the years as researchers have looked at it closely. Reinganum (1981), Lakonishok and Shapiro (1986) and Fama (1992) suggest that the CAPM’s risk measure (beta) and the returns of shares since the mid 1960’s show little if any correlation. This layout of the remainder of the document is as follows; the history of the CAPM will be discussed in order to comment on some researcher’s belief that the model is dead. The alternative methods that have been developed will be included.