Capital Asset Pricing Model

Background

The Capital Asset Pricing Model (CAPM) is a fundamental financial model used to predict the returns on risky assets by modelling market equilibrium. The CAPM incorporates several assumptions to create robust and precise predictions about financial returns.

Historical Context

CAPM was developed in the 1960s by William Sharpe, John Lintner, Jan Mossin, and Jack Treynor. This model built upon Harry Markowitz’s work on modern portfolio theory, establishing a clearer understanding of the relationship between risk and return in an efficient market system.

Definitions and Concepts

• Infinite Divisibility of Assets: Assumes assets can be divided into infinitely small shares without losing value.
• No Transaction Costs: Assumes investors incur no costs when buying or selling assets.
• No Taxes: Assumes a tax-free environment for calculations.
• One-Period Investment Horizon: All investors plan investments over the same single period.
• Mean-Variance Preferences: Investors prefer higher returns and lower risk (variance).
• Borrow and Lend at Risk-Free Rate: Investors can borrow or lend unlimited amounts at a constant risk-free interest rate.

Major Analytical Frameworks

Classical Economics

Classical economics allows for basic market equilibriums and serves as an underpinning for CAPM by expecting rational agents and constant rates of return for given risk levels.

Neoclassical Economics

Neoclassical economics advances its methodologies by assuming rational behavior leading toward equilibriums analyzed via sets of supply and demand intersecting in markets, forming foundations upon which CAPM is constructed.

Keynesian Economic

Though Keynesian theory emphasizes active government intervention which may deviate markets from equilibrium, CAPM simplifies it by assuming no outside interference in market mechanisms.

Marxian Economics

CAPM does not incorporate labour-centric profit views central to Marxian economics but still finds utility in analyzing capitalist market structures from purely asset-based return perspectives.

Institutional Economics

While institutional economics incorporates societal norms and legal frameworks influencing markets, CAPM operates within an idealized model often overlooking these nuances.

Behavioral Economics

CAPM diverges here since it assumes rational investor behavior, differing from behavioral finance’s focus on psychological impacts on market behavior.

Post-Keynesian Economics

This approach, focusing on economic diversity and deviations from rapid equilibrium, contrasts with CAPM’s structured path to equilibrium based on streamlined assumptions.

Austrian Economics

The Austrian focus on methodological individualism and error-driven market adjustments finds some philosophical strands in CAPM’s reliance on individual optimizing behavior though in highly idealistic constructs.

Development Economics

Focused on macroeconomic policies over technical analyses, development economics rarely utilizes CAPM due to the latter’s focus on financial asset-return calculations and efficient markets.

Monetarism

Monetarism’s view situates around controlling the money supply affecting macroeconomic outcomes; CAPM remains more micro-economically driven within financial spheres.

Comparative Analysis

CAPM analyzed returns exceeding the risk-free rate attributed to systematic market risks, known as the risk-premium. By distinguishing between market-wide risk and individual asset risk, CAPM aids investors in evaluating potentially rewarding portfolios aligned with their risk preferences.

Case Studies

Examining how major funds apply CAPM for portfolio structuring or analysing its deviation conceptual fits with real-world mechanics often lead institutions actively balancing performance measurement and runway for adjusted forecasts in returns.

Suggested Books for Further Studies

1. “Capital Ideas: The Improbable Origins of Modern Wall Street” by Peter L. Bernstein
2. “Investment Valuation: Tools and Techniques for Determining the Value of Any Asset” by Aswath Damodaran
3. “Modern Portfolio Theory and Investment Analysis” by Edwin J. Elton and Martin J. Gruber

Related Terms with Definitions

1. Risk-Free Rate: The theoretical return expected from an investment with absolutely no risk.
2. Systematic Risk: The inherent risk tied to the entire market or market segment.
3. Risk Premium: Additional return expected from an investment, over the risk-free rate, to compensate for exposure to greater risk.
4. Efficient Portfolio: A portfolio constructed to provide the highest expected return for a defined level of risk.
5. Security Market Line (SML): Represents the expected return of an asset at varying levels of systematic, non-diversifiable risk.