Erasmus university rotterdam

History of the CAPM

Modern portfolio theory was first developed by Markowitz, who constructed the mean-variance model. The model was designed to construct the optimal portfolio based on the idea that risk and return have a positive relationship. Markowitz showed that stocks are related to each other and risk can be decreased through diversification. The asset pricing theory framework is designed to identify and measure risk in addition to assigning rewards for risk bearing. The theory helps us understand why expected returns change through time.

The CAPM model was derived from this framework. The CAPM model is one of the most influential and fundamental models used in financial economics. Basically, it examines the relationship between the return and the risk of an asset. The model requires investors to be compensated for the time value of money. The risk is reflected as the risk free rate and beta respectively. The CAPM claims that the selection of the portfolio will depend upon the risk free rate and the market return. A very important consequence of this model is the separation theorem, which says that in the capital markets the risk has two components: diversifiable (non-systematic) risk and non-diversifiable (systematic) risk. When pricing assets, the only significant risk is systematic risk, since investors can get rid of the non-systematic risk through diversification. Sharpe (1964) and Lintner (1965) show that beta is the true measure of risk.

The asset pricing framework assumes that investors like higher rather than lower expected returns, dislike risk, and hold well diversified portfolios. The model relies on the assumptions that the individuals are risk averse and have homogenous expectations i.e. they have the same expectations and estimates on mean, variance and covariance among the returns and beta is the only measure of the market variance. A positive linear relationship between the expected return and the beta of a security is implied by the CAPM. This means that stocks with a larger beta will demand a higher expected return than a stock with a smaller beta.

Stocks with a beta lower than 1 are considered passive stocks, and stocks with a beta higher than 1 are considered aggressive and risky. Depending on the appetite toward risk, investors would choose the stocks in their portfolio according to the value of beta. Today, the CAPM remains popular among financial practitioners (Pereiro, 2002). The CAPM is both used to determine the cost of capital for an investment project of a company as well as to estimate the expected returns of stocks. Many financial decisions are based on the estimation of the cost of equity of the investment. According to Ben Naceur and Chaibi (2007). The cost of equity is also important for portfolio management, project valuations, performance evaluation and capital budgeting. The capital asset framework helps to illustrate the risk of a particular project or acquisition, and assign a discount rate that is appropriate for that risk. Projects that have a higher rate of return than predicted by the theory create value for corporations. In addition it helps to identify overvalued and undervalues assets for portfolio investments purposes. The classical version of the CAPM is the most widely used model to estimate a firm’s weighted average cost of capital (WACC) (Graham and Harvey, 2001).