The Capital Asset Pricing Model (CAPM): An Overview

Abstract

Although the Capital Asset Pricing Model (CAPM) has been one of the most useful and frequently used theories in determining the required rate of return of an asset, the use of this model has been controversial since early 1960s. The CAPM was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modem portfolio theory. The model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that assets' non-diversifiable risk. The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor enough to invalidate the way it is used in applications. This research aims to shed the light on this model by discussing the assumptions, the development of the Sharpe-Lintner model, and reviewing the literature on relaxation of the model assumptions and the critiques of the CAPM. The paper will discuss the theoretical failings that resulted from simplifying many of these assumptions. Finally, the Arbitrage Pricing Model will be discussed as an extension for the CAPM and attempt to overcome the shortcomings of the CAPM.