The capital asset pricing model and multifactor models

Abstract

The previous chapter introduced the contingent-states framework and discussed in a general way how asset prices are determined. We now turn to the major topic of models of expected returns. These are models that result in equations in which the expected return on an asset is a function of one or more variables that measure the risk of the asset. At least three approaches to modelling expected returns have been developed: the CAPM; the arbitrage pricing theory (APT) and multifactor models; and the consumption CAPM. The current chapter starts with a derivation of the standard CAPM, which assumes that there is a risk-free asset. The standard CAPM is important for this book because it is widely used in practice to estimate the cost of equity, and because much of the applied analysis in Part II assumes that the cost of equity is modelled by the standard CAPM. The Black version of the CAPM, which does not assume that there is a risk-free asset, is also described. There are shorter sections on arbitrage pricing theory and multifactor models, and the chapter ends with a brief summary of relevant evidence. The consumption CAPM is considered in Chapter 4.