The Capital Asset Pricing Model

Two main problem types dominate the discipline of investment science The first is to determine the best course of action in an investment situation. Problems of this type include how to devise the best portfolio, how to devise the optimal strategy for managing an investment, how to select from a group of potential investment projects, and so forth. Several examples of such problems were treated in Part I of this book. The second type of problem is to determine the correct, arbitrage-free, fair, or equilibrium price of an asset We saw examples of this in Part 1 as well, such as the formula for the correct price of a bond in terms of the term structure of interest rates, and the formula for the appropriate value of a firm.

This chapter concentrates mainly on the pricing issue, it deduces the correct price of a risky asset within the framework of the mean-variance setting, The result is the capital asset pricing model (CAPM) developed primarily by Sharpe, Lintner, and Mossin, which follows logically from the Markowitz mean-variance portfolio theory described in the previous chapter. Later in this chapter we discuss how this result can be applied to investment decision problems

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