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The Capital Asset Pricing Model

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Abstract

One of the problems with implementing portfolio theory is that a huge number of covariances have to be calculated when assessing the risk to a portfolio. While the Markowitz model provides a relatively straightforward solution for the two-asset case, it becomes much more complicated to solve for the efficiency frontier when there are more than two assets. In the N securities case, it is necessary to calculate (N2N)/2 covariances. This means with 100 securities one would need to calculate 4,950 covariances, and with 500 securities this increases to 124,750 covariances. The amount of calculation required for the Markowitz method was one of the factors stimulating other approaches to investment management. The foundations for the capital asset pricing model (CAPM) were laid by portfolio theory and the introduction of a risk-free asset. Underlying the CAPM is, however, the basic idea that agents will only accept increased risk for an increased expected rate of return. The CAPM attempts to place a price on the increased risk and show that the market will only place a price on market risk, that is risk that cannot be diversified away. In its turn, the expected return tells us how any security or any portfolio should be priced.

Keywords

Risk Premium Systematic Risk Efficiency Frontier Market Risk Total Risk 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

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Further reading

  1. Blake, D. (2000) Financial Market Analysis 2nd edn, McGraw-Hill.Google Scholar
  2. Elton, E., Gruber, M., Brown, S. and Goetzmann, W.N. (2002) Modern Portfolio Theory and Investment Analysis Wiley.Google Scholar
  3. Sharpe, W.F., Alexander, G.J. and Baley, J. (2002) Investments 6th edn, Pearson.Google Scholar

Chapter 8: The Capital Asset Pricing Model

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© Keith Pilbeam 2005

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