Capital Asset Pricing Model

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Capital Asset Pricing Model

The Capital Asset Pricing Model otherwise know as CAPM defines the relationship between risk and return for individual securities. William Sharpe published the capital asset pricing model in 1964. CAPM extended Harry Markowitz's portfolio theory to introduce the notions of systematic and specific risk. For his work on CAPM, Sharpe shared the 1990 Nobel Prize in Economics with Harry Markowitz and Merton Miller CAPM assumes the concept of a logical investor, assumes a perfect market, and uses a measure of investment risk known as a Beta. When CAPM assumes these three concepts above there has to be a definition to describe the assumptions. Therefore when we assume a logical investor we are actually referring to an investor that makes his or her investments based upon the expectation of a return. Investors will anticipate their return by analyzing the stock market's average rate of return and that will be their expectation when looking into a specific security. If they are not going to anticipate their return to equal the markets average rate of return then there will be no reason to invest. You invest to make a profit. Investors invest to make a profit. Furthermore a logical investor accepts the market rate of risk. Since they are anticipating the average market rate of return they also have to be willing to accept the market rate of risk. Logical investors might be willing to take on a greater rate of risk than the average market rate of risk but, in doing so they will be required to be rewarded or compensated with a higher rate of return from that more risky investment. So, on the flip side if a logical investor invested in a security with a lower rate of risk than the market average they would have to assume and understand that their return will also be lower than the average market rate of return. More risk, more money. Lower risk, less money. Assuming a perfect market in CAPM (if there is such a thing) takes these...
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