Capital Asset Pricing Model Analysis

The Capital Asset Pricing Model is the pioneer model in asset pricing. The model was initially introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John Linter (1965) and Jan Mossin (1966). They developed the model independently on the earlier work of Henry Markowitz (1959) on diversification and modern portfolio management. But Sharpe (1964) Capital Asset Pricing Model is the most important asset pricing equilibrium model that provides the relationship between expected return and risk associated with capital assets. For the contribution in financial economics Sharpe, Markowitz and Miller was awarded Nobel Prize in 1990 jointly.

The capital asset pricing model is used to find out a theoretically required rate of return of a risky

That’s why Markowitz model is also called a “mean-variance model”. It assumes that investors are well planner, risk-averse and opportunity maximizer who select points that are located on the minimum variance frontier and therefore, selection of portfolio depends on investor’s risk-return utility function. Thus investors choose a portfolio of single period investment and look closely on the mean and variance of their investment

All the assumptions are discussed below:

1. All the investors in the market can borrow or lend any amount of money at risk free rate of return which is similar for all investors and does not depend on the amount borrowed or lend.

2. All investors take a position on the efficient frontier, where all investments gives highest expected return for a specific level of risk or lowest risk for a specific level of expected return. Investors are risk averse individuals whose goal is maximizing the expected utility of their assets and aim only on their return (mean) and the related risk (variance). They have also the similar time horizon.

3. All investors have homogenous expectations which mean that they estimate the same distributions for the future rates of