15.5 Capital asset pricing model (CAPM)

CAPM

The Capital Asset Pricing Model (CAPM) is an economic model for valuing stocks, securities, derivatives and/or assets by relating risk and expected return. CAPM is based on the idea that investors demand additional expected return (called the risk premium) if they are asked to accept additional risk. It was introduced by Treynor, Sharpe and Lintner. By introducing the notions of systematic and specific risk, it extended the portfolio theory. In 1990, William Sharpe was announced the Nobel Prize 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, 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 a systematic risk but not for taking a specific risk. This is because a specific risk can be diversified away. When an investor holds a 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.