Capital Asset Prices: a Theory of Market Equilibrium Under Conditions of Risk

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American Finance Association

Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk Author(s): William F. Sharpe Source: The Journal of Finance, Vol. 19, No. 3 (Sep., 1964), pp. 425-442 Published by: Blackwell Publishing for the American Finance Association Stable URL: http://www.jstor.org/stable/2977928 . Accessed: 23/08/2011 00:15 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

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The
VOL. XIX

journal

of

FINANCE
No. 3

SEPTEMBER 1964

CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK* WILLIAM F. SHARPEt I. INTRODUCTION

ONE OF THE PROBLEMSwhich has plagued those attempting to predict the

behavior of capital markets is the absence of a body of positive microeconomic theory dealing with conditions of risk. Although many useful insights can be obtained from the traditional models of investment under conditions of certainty, the pervasive influence of risk in financial transactions has forced those working in this area to adopt models of price behavior which are little more than assertions. A typical classroom explanation of the determination of capital asset prices, for example, usually begins with a careful and relatively rigorous description of the process through which individual preferences and physical relationships interact to determine an equilibriumpure interest rate. This is generally followed by the assertion that somehow a market risk-premium is also determined,with the prices of assets adjusting accordingly to account for differencesin their risk. A useful representation of the view of the capital market implied in such discussions is illustrated in Figure 1. In equilibrium, capital asset prices have adjusted so that the investor, if he follows rational procedures (primarily diversification), is able to attain any desired point along a capital market line.' He may obtain a higher expected rate of return on his holdings only by incurring additional risk. In effect, the market presents him with two prices: the price of time, or the pure interest rate (shown by the intersection of the line with the horizontal axis) and the price of risk, the additional expected return per unit of risk borne (the reciprocal of the slope of the line). * A great many people provided comments on early versions of this paper which led to major improvementsin the exposition. In addition to the referees, who were most helpful, the author wishes to express his appreciation to Dr. Harry Markowitz of the RAND Corporation,Professor Jack Hirshleifer of the University of California at Los Angeles, and to Professors Yoram Barzel, George Brabb, Bruce Johnson, Walter Oi and R. Haney Scott of the University of Washington. t AssociateProfessorof Operations Research,Universityof Washington. 1. Althoughsome discussionsare also consistentwith a non-linear (but monotonic) curve.

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The Journalof Finance

At present there is no theory describing the manner in which the price of risk results from the basic influences of investor preferences, the physical attributes of capital assets, etc. Moreover, lacking such a theory, it is difficult to give any real meaning to the relationship between the price of a single asset and its risk. Through diversification, some of the risk inherent in an asset can be avoided so that its total risk is obviously not the...
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