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Capital asset pricing model

Capital Asset Pricing Model (commonly referred to as CAPM) was introduced by
William Sharpe, Lintner and Mossin independently, though it is commonly
attributed only to the first of them, who published it earliest (in 1964),
and subsequently received (jointly with Harry Markowitz and Merton Miller)
the The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel
for his contribution to the field of financial economics.

The risk of a portfolio is comprised of systematic risk and specific risk.
Specific risk is the risk associated with individual assets. Systematic risk
refers to the risk common to all securities. CAPM considers the market
portfolio (the value-weighted portfolio comprising every asset) as the
optimal portfolio. The beta of a stock or a portfolio (e.g. mutual fund)
measures its sensitivity to the movement of the broader market. Betas
exceeding one signify more than average riskiness, stock market index has a
beta of one. Most of mutual funds portfolios have systematic risk smaller
than one.

According to the CAPM a the required rate of return of a stock is derived by:

 rs = β ( rm - rf ) + rf


 rs is the required rate of return on a stock
 rm is the market rate of return
 rf is the risk free interest rate
 β is the beta of the stock


Shortcomings of CAPM

Does not edequately explain the variation in stock returns. Market portfolio
and its return are unobservable and have to be estimated, therefore the
model is not testable.
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