The Capital Asset Pricing Model CAPM was introduced by Treynor ('61), Sharpe ('64) and Lintner ('65).

By introducing the notions of systematic and specific risk, it extended the portfolio theory. In 1990, William Sharpe was Nobel price winner for Economics. "For his contributions to the theory of price formation for financial assets, the so-called Capital Asset Pricing Model (CAPM)." The CAPM model says that the expected return that the investors will demand, is equal to: the rate on a risk-free security plus a risk premium. If the expected return is not equal to or higher than the required return, the investors will refuse to invest and the investment should not be undertaken. CAPM decomposes a portfolio's risk into systematic risk and specific risk. Systematic risk is the risk of holding the market portfolio. When the market moves, each individual asset is more or less affected. To the extent that any asset participates in such general market moves, that asset entails systematic risk. Specific risk is the risk which is unique for an individual asset. It represents the component of an asset's return which is not correlated with general market moves. According to CAPM, the marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away. When an investor holds the market portfolio, each individual asset in that portfolio entails specific risk. But through diversification, the investor's net exposure is just the systematic risk of the market portfolio. CAPM formula The CAPM formula is: Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium) or: r = Rf + Beta x (RM - Rf) { Another version of the formula is: r-Rf = Beta x (RM - Rf) } where:

r is the expected return rate on a security; Rf is the rate of a "risk-free" investment, i.e. cash; RM is the return rate of the appropriate asset class.

Beta is the overall risk in investing in a large market, like the New York Stock Exchange. Beta, by definition equals 1,00000 exactly. Each company also has a Beta. The Beta of a company is that company's risk compared to the Beta (Risk) of the overall market. If the company has a Beta of 3.0, then it is supposed to be 3 times more risky than the overall market. Beta indicates the volatility of the security, relative to the asset class. Investing in individual securities A consequence of CAPM thinking is that it implies that investing in individual stocks is useless, because one can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class. This is why die-hard followers of CAPM avoid securities, and instead build portfolios merely out of low-cost index funds. Assumptions of the Capital Asset Pricing Model Note! The Capital Asset Pricing Model is a ceteris paribus model. It is only valid within a special set of assumptions. These are:

Investors are risk averse individuals who maximize the expected utility of their end of period wealth. Implication: The model is a one period model. Investors have homogenous expectations (beliefs) about asset returns. Implication: all investors perceive identical opportunity sets. This means everyone has the same information at the same time. Asset returns are distributed by the normal distribution. There exists a risk free asset and investors may borrow or lend unlimited amounts of this asset at a constant rate: the risk free rate. There is a definite number of assets and their quantities are fixated within the one period world. All assets are perfectly divisible and priced in a perfectly competitive marked. Implication: e.g. human capital is non-existing (it is not divisible and it can't be owned as an asset). Asset markets are frictionless and information is costless and simultaneously available to all investors. Implication: borrowing rate equals the lending rate. There are no market imperfections such as taxes, regulations, or restrictions on short selling.

Normally, all of the assumptions mentioned above are neither valid nor fulfilled. However, CAPM anyway remains one of the most used investments models to determine risk and return. CAPM Formula The way CAPM helps investors calculate their return is by using a simple formula which explains the relationship between expected return and risk: Expected Rate of Return = r = rf + (rm - rf) Where:

rf = The risk-free interest rate is the interest rate the investor would expect to receive from a risk-free investment. Typically, US Treasury Bills are used for US dollars and German Government bills are used for the Euro. = A stock beta is used to mathematically describe the relationship between the movements of an individual stock versus the market itself. Investors can use a stock's beta to measure the risk of a security versus the market. rm = The expected market return is the return the investor would expect to receive from a broad stock market indicator such as the S&P 500 Index. For example, over the last 17 years or so, the S&P 500 has yielded investors an average annual return of around 8.10%.

So what exactly is this CAPM formula telling us? The formula states that the expected return of a stock is equal to the risk-free rate of interest plus the risk associated with all common stocks (market premium risk) adjusted for the risk of the common stock we're examining. This means the investor can expect a rate of return on this asset that compensates them for both the risk-free rate of interest, the stock market's risk and this particular stock's risk - it all makes sense. Limitations to CAPM Capm has a number of unrealistic assumptions such as: 1-perfect capital market exists,i.e the market is efficient market (in equilibrium). 2-lending and borrowing can take place at risk free rates. 3-all investors have the same expectations about return and risk 4-capm works only when we r well diversified, only a diversied portfolio investor can use capm(unsystematic

risk is not accounted for into capm) 5-risk is measured on the basis of historic returns patterns and assumption is that returns pattern will repeat in the future . 6-beta worked out from std. Dev. Of returns which are in turn measured on the basis of historic return pattern and also it is assumed that the pattern will repeat in future. Capital asset pricing model has the following limitations: o It is based on unrealistic assumptions. o It id difficult to test the validity of Capital asset pricing model. o Betas do not remain stable over time. Unrealistic assumptions Capital asset pricing model is based on a number of assumptions that are far from the reality. For example it is very difficult to find a risk free security. A short term highly liquid government security is considered as a risk free security. It is unlikely that the government will default, but inflation causes uncertain about the real rate of return. The assumption of the equality of the lending and borrowing rates is also not correct. In practice these rates differ. Further investors may not hold highly diversified portfolios or the market indices may not well diversify. Under these circumstances capital asset pricing model may not accurately explain the investment behavior of investors and beta may fail to capture the risk of investment. Difficult to validity Most of assumptions may not be very critical for its practical validity. Therefore is the empirical validity of capital asset pricing model. Need to establish that the beta is able to measure the risk of a security and that there is a significant correlation between beta and the expected return. The empirical results have given mixed results. The earlier tests showed that there was a positive relation between returns and betas. However the relationship was not as strong as predicted by capital asset pricing model. Further these results revealed that returns were also related to other measures of risk, including the firm specific risk. In subsequent research some studies did not find any relationship between betas and returns. On the other hand other factors such as size and the market value and book value ratios were found as significantly related to returns.

All empirical studies testing capital asset pricing model have a conceptual problem. We need data on expected prices to test it. Unfortunately, in practice the researchers have to work with the actual past data. Thus this will introduce bias in the empirical results. Betas do not remain stable over time Stability of beta, beta is a measure of a securities future risk. But investors do not further data to estimate beta. What they have are past data about the share prices and the market portfolio. Thus, they can only estimate beta based on historical data. Investors can use historical beta as the measure of future risk only if it is stable over time. Most research has shown that the betas of individual securities are not stable over time. This implies that historical betas are poor indicators of the future risk of securities. Capital asset pricing model is a useful device for understanding the risk return relationship in spite of its limitations. It provides a logical and quantitative approach for estimating risk. It is better than many alternative subjective methods of determining risk and risk premium. One major problem is that many times the risk of an asset is not captured by beta alone.