Abstract
The capital asset pricing model (CAPM) is an influential paradigm in financial risk management. It formalizes mean-variance optimization of a risky portfolio given the presence of a risk-free investment such as short-term government bonds. The CAPM defines the price of financial assets according to the premium demanded by investors for bearing excess risk.
Highlights
Beta’s prominence in the theoretical literature and in practical applications of the capital asset pricing model (CAPM) justifies a closer look at the basic unit of financial co-movement [23], By expressing covariance between a single security and the whole market, beta supplies the simplest measure of systematic risk not reducible through diversification [24] (p. 281)
Florida Public Service Commission, for instance, uses a utility-specific, regulatory variant of the CAPM to calculate the cost of equity for water and wastewater utilities [49] (p. 89): ru = r f + β u rm − r f where the subscript u indicates the rate of return required to attract investors, and measures risk borne by comparable firms engaged in the transport of water and wastewater [50]
Benchmarking to an index, the logical consequence of William Sharpe’s critique of active management [54], gives rise to a bifurcated CAPM distinguishing between indexed returns and the risk/return profile of active managers working on behalf of institutional investors [64]
Summary
Publisher’s Note: MDPI stays neutral with regard to jurisdictional claims in published maps and institutional affiliations. The CAPM traces its origins to “general models” seeking to solve “the problem of capital asset pricing under uncertainty” [1] The CAPM presumes that rational, welfare-maximizing agents will understand and act upon an “objective probability law” that quantifies the relationship between risk and return [3] The fundamental expectation that returns in excess of a risk-free baseline “should vary positively and proportionately to market volatility” is properly regarded as the “first law of finance” [5] It describes the Treynor and Sharpe ratios.
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