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What is the Capital Asset Pricing Model?

1990 Nobel laureate William F. Sharpe helped develop the CAPM; the most influential, debated and tested of all models in finance

Paul D. Kaplan 9 August, 2018 | 8:13AM

 

 

Paul Kaplan: I'm Paul Kaplan, research director at Morningstar Canada. In a previous video I looked back on one of the three laureates of the 1990 Nobel Prize in Economic Sciences, Harry Markowitz. Today I look back on the major contribution of one of the other 1990 Nobel laureates: William F. Sharpe.

The Nobel committee cited Sharpe’s contribution to the development of the Capital Asset Pricing Model, or the CAPM as it is commonly known, as the reason for his share of the prize.

In developing the CAPM, Sharpe built upon the work of his co-laureate, Harry Markowitz. While Markowitz focused on how investors should build their portfolios, Sharpe asked what the implications for the market are as a whole if all investors used Markowitz’s approach to build portfolios, and if they could borrow and lend at a single riskless rate. Three major conclusions emerge from these assumptions:

Firstly, the market portfolio, which consists of all securities weighted by their market capitalisations, has the highest expected return for its level of risk, what Markowitz described as being on the efficient frontier.

Secondly, all investors hold either a leveraged position in the market portfolio, to raise expected return and risk above that of the market portfolio, or combine the market portfolio with the risk-free asset, to take on less risk than the market portfolio and thus less expected return. This conclusion of the CAPM is the theoretical basis for index investing.

Finally, according to the CAPM, the expected excess return of any security or portfolio is the security or portfolio’s systematic risk, known as beta, times the expected excess return of the market portfolio.

Beta is one of the most used statistics in investment analysis. As suggested by the CAPM itself, it is used to estimate the expected returns of securities. But it is also used in performance measurement, as exemplified by Morningstar’s Modern Portfolio Theory statistics. These statistics include beta itself, alpha, which is beta-adjusted performance measure, and the Treynor Ratio, which is the average historical return, divided by beta. For the definition of these statistics, please see the related links for this video.

The CAPM is the most influential, debated and tested of all models in finance. As one its main developers, William F. Sharpe richly deserved a share of the Nobel Prize.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Paul D. Kaplan  

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