Abstract
The capital asset pricing model (CAPM) is a mathematical model that explains the relationship between risk and return in a rational equilibrium market. The model is used in finance to determine a theoretically appropriate required rate of return asset, if that asset is to be added to an existing well-diversified portfolio, provided that asset's non-diversifiable risk. The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (a) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.
The capital asset pricing model (CAPM) theory assumes that an investor expects a yield on a certain security equivalent to the risk free rate (say that rate achievable on six-month Treasury bills) plus a premium based on market variability of return X a market risk premium. In Winter 1991, the m?rket risk premium on listed U.S. common stocks appears to have been about 6.5%, according to statistics published in the Quarterly Review, Winter 1991, by the Federal Reserve Bank of New York (though the Ibbotson study found it to exceed 8% from the mid 1920s through 1987). Thus in a period of 4% inflation, the T-bill rate might be appropriately 4.5 to 5%; a four- or five-year Treasury note should have a yield of 5.5 to 6%; Treasury bonds should yield a percent higher than this; and corporate bond yields should have even higher returns to compensate for their additional credit or business risk.
