Modern Portfolio Theory: The Capital Asset Pricing Model

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Introduction Development of CAPM The Capital Asset Pricing Model (CAPM) was introduced by William Sharpe (1964) and John Lintner (1965). They built on the earlier work done by Harry Markowitz (1952, 1959) and James Tobin (1958) in the area of Modern Portfolio Theory (MPT). Tobin’s (1958) seperation theorem suggests the method in which investors, depending on their attitude towards risk, should form their portfolios by adjusting the propositions of their investments between a risk free asset and the market portfolio. In Markowitz’s (1952) paper, Portfolio Selection, he showed how a subset of the possible portfolio compositions, the efficient frontier, represented the lowest level of risk for a given level of return. Markowitz (1959) further…show more content…
The CAPM predicts a positive linear relation between risk and expected return of a risky asset of the form: E{Ri} = Rf + βi (E{Rm} - Rf) Where E{Ri} is the expected return on security i, E{Rm} is the expected return of the market portfolio, Rf is the risk-free rate and βi is a measure of risk for security i. The CAPM conveys the notion that securities are priced so that the expected returns will compensate investors for the expected risks. The beta is a measure of how sensitive the individual stock is to changes in the market as a whole. If β > 1, the asset is more volatile than the market. If β = 1, the asset will move with the market. If β < 1 the asset will fluctuate less than the market as a whole and will have a lower rate of return. Empirical…show more content…
(Fama and French, 2004). The CAPM states that there is a positive, linear relationship between the stock’s expected return and its systematic risk, beta, and that beta is a sufficient variable to explain cross sectional stock returns. Early empirical tests of the CAPM largely supported this main prediction. One of the first empirical studies of the model was carried out by Black, Jensen and Scholes (1972). They used all of the stocks on the NYSE from 1931 to 1965, in order to create 10 portfolios with varying historical beta estimates. They then regressed average monthly excess returns on beta. They found that their data showed support for CAPM as it was broadly consistent with the predictions of the model. Another early empirical study of CAPM is by Fama and MacBeth (1973). They tested if there was a positive linear relationship between average returns and beta. They also examined whether the squared value of beta and the volatility of the return on an asset can explain the residual variation in average returns across assets that is not explained by beta alone. Using a similar methodology to Black, Jensen and Scholes (1972), they formed 20 portfolios from stocks traded on the NYSE. By using return data for the period from 1926–1968, Fama and MacBeth found that the data generally supported the CAPM

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