Absence of arbitrage is a powerful economic principle for establishing relative pricing. In itself, however, it is not a market equilibrium model. William Sharpe (in 1964),16 John Lintner (in 1965),17 and Jan Mossin (in 1966),18 developed a theoretical equilibrium model of market prices called the Capital Asset Pricing Model (CAPM). As anticipated 60 years earlier by Walras and Pareto, Sharpe, Lintner, and Mossin developed the consequences of Markowitz's portfolio selection into a full-fledged stochastic general equilibrium theory.
Asset pricing models categorize risk factors into two types. The first type is risk factors that cannot be diversified away via the Markowitz framework. That is, no matter what the investor does, the investor cannot eliminate these risk factors. These risk factors are referred to as systematic risk factors or nondiversifiable risk factors. The second type is risk factors that can be eliminated via diversification. These risk factors are unique to the asset and are referred to as unsystematic risk factors or diversifiable risk factors.
The CAPM has only one systematic risk factor—the risk of the overall movement of the market. This risk factor is referred to as "market risk." This is the risk associated with holding a portfolio consisting of all assets, called the "market portfolio." In the market portfolio, an asset is held in proportion to its market value. So, for example, if the total market value of all assets is $X and the market value of asset j is $Y, then asset j will comprise $Y/$X of the market portfolio.
16 William F. Sharpe, "Capital Asset Prices," Journal of Finance (September 1964), pp. 425-442.
17 John Lintner, "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolio and Capital Budgets," Review of Economics and Statistics (February 1965), pp. 13-37.
18 Jan Mossin, "Equilibrium in a Capital Asset Market," Econometrica (October 1966), pp. 768-783.
The expected return for an asset i according to the CAPM is equal to the risk-free rate plus a risk premium. The risk premium is the product of (1) the sensitivity of the return of asset i to the return of the market portfolio and (2) the difference between the expected return on the market portfolio and the risk-free rate. It measures the potential reward for taking on the risk of the market above what can be earned by investing in an asset that offers a risk-free rate. Taken together, the risk premium is a product of the quantity of market risk and the potential compensation of taking on market risk (as measured by the second component).
The CAPM was highly appealing from the theoretical point of view. It was the first general-equilibrium model of a market that admitted testing with econometric tools. A critical challenge to the empirical testing of the CAPM is the identification of the market portfolio.19
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