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What Is Capital Asset Pricing Model – CAPM

CAPM or Capital Asset Pricing Model is a theoretical concept which elaborates the concept behind formation of the price assets in the market. Jan Mohsin , John Lintner and William Sharpe years back introduced a portfolio theory i.e. Markowitz which analyzed the risk and return relationship in market of capital, when the people who invested actually behaved in accordance with prescription of Markowitz (portfolio theory). This theory was later extended, which is now known as Capital Asset Pricing Model.

There are few implications for Capital Asset Pricing Model:

a) Efficient portfolio seeks risk-return relationship

b) Every individual asset or security seeks risk-return relationship

c) Under and over-valued assets identification that are traded in market

d) The assets which are about to be traded in market, their costing

e) Leverage effect on the price of equity

f) Decisions related to capital budgeting and capital cost

g) Risks involved due to project portfolio’s diversification

Capital Asset Pricing Model elements:

a) CAPM has two elements:

b) Capital Market Line

c) Security Market Line

Capital Market Line:

Capital market lines determine the risk and return relationship for effective portfolios and have two functions.

it determines the risk and return relationship to the investors with efficient portfolios.
It also showcases that standard deviation for return of portfolio is basically proper measure of the risk involved in efficient portfolio.

Security Market Line:

Security market line renders graphical representation of the Capital Asset Pricing Model and also depicts the perils pf market price in market capital. It is the adverse risk investors that consider risk premium in investing in assists that are risky. Variability in the return is what risk is, and the net risk can be systematic or unsystematic or even both. However, the unsystematic risk can be eliminated, if the investor diversifies the investment made in portfolio but systematic risk cannot be avoided. In fact, the capital market theory suggests that market only pays for systematic risk.

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