Capital Asset Pricing Model

Capital Asset Pricing Model was put forward separately by William Sharpe, Jan Mossin, John Linter and Jack Treynor. The model was developed upon the earlier theory founded by Harry Markowitz known as the Portfolio Theory.
The Capital Asset Pricing Model is concerned with finding out the suitable return rate of an asset when the asset is about to become a part of an existing diversified portfolio. The Capital Asset Pricing Model is also concerned with the market risk and sensitivity of the assets regarding these risks.

At the same time, CAPM also considers return from a particular asset that is theoretically denoted as risk free.Capital Asset Pricing Model categorizes the risk related to the portfolio in two different types such as systematic risk and specific risk.

The systematic risk denotes the risk factor related with holding the market portfolio because the fluctuations in the market influence the individual assets also. On the other hand, specific risks represent those risks that are different for each portfolio and at the same time, the return from an asset is uncorrelated with the fluctuations of the market.
Capital Asset Pricing Model holds that all those investors who are taking systematic risks are compensated by the marketplace. On the other hand, the marketplace never compensates those investors who are taking specific risk. The prime reason behind this is that there is a certain process through which the specific risks can be minimized. A portfolio consists of different individual assets and each one of these assets implicates specific risk. By proper use of diversification the specific risks can be managed.

Capital Asset Pricing Model or CAPM holds that the returns that are expected from a security or the expected returns from a portfolio is in equal proportion with the combination of a risk premium and the rate on a security that is risk-free. There are certain situations where the anticipated return from the investment is not more than the required rate or if the rate is lower than the required rate, money should not be invested.

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Last Updated on : 1st July 2013