The Capital Aset Pricing Model (capm)

THE CAPITAL ASET PRICING MODEL (CAPM)

In the chronological development of modern financial management, portfolio theory came first with Markowitz in 1952. It was not until 1964 that William Sharpe derived the capital Asset Pricing Model (CAPM)1 based on Markowitz's portfolio theory. For example, a key assumption of the CAPM is that investors hold highly diversified portfolios and thus can eliminate a significant proportion of total risk.

The CAPM was a breakthrough in modern finance because for the first time a model became available which enable academic, financiers and investors to link the risk and return for an asset together, and which explained the underlying mechanism of asset pricing in capital markets.

TYPES OF INVESTMENT RISK

In the preceding chapter we have seen how the total risk (as represented by the standard deviation, ) of a two-security portfolio can be significantly reduced by combining securities whose returns are negatively correlated, or at least have low positive correlation – the principle of diversification.

According to the CAMP, the total risk of a security or portfolio of securities can be split into two specific types, systematic risk and unsystematic risk. This is sometimes referred to as risk partitioning, as follows :

Total risk = Systematic risk + Unsystematic risk

• Systematic (or market) risk cannot be diversified away : it is the risk which arises from market factors and is also frequently referred to as undiversifiable risk. It is due to factors which systematically impact on most firms, such as general or macroeconomic conditions (e.g. balance of payments, inflation and interest rates). It may help you remember which type is which if you think of systematic risk as arising from risk factors associated with the general economic and financial system.

• Unsystematic (or specific) risk can be diversified away by creating a large enough portfolio of securities : it is also often called diversifiable risk or company-unique risk. It is the risk which relates, or is unique, to a particular firm. Factors such as winning a new contract, an industrial dispute, or the discovery of a new technology or product would contribute to unsystematic risk.

The relationship between total portfolio risk, p, and portfolio size can be shown diagrammatically as in Figure below. Notice that total risk diminishes as the number of assets or securities in the portfolio increases, but also observe that unsystematic risk does not disappear completely and that systematic risk remains unaffected by portfolio size.

THE CAPM MODEL

We have previously described the CAPM as