capital asset pricing model

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A model of equilibrium in financial markets that generates very precise predictions about the structure of returns on risky assets. The CAPM assumes the infinite divisibility of assets, no transaction costs, and no taxes. It also assumes that all investors have a one-period investment horizon, hold the same expectations about asset returns, have mean-variance preferences, and are able to borrow and lend at a risk-free rate of interest. Under these assumptions the equilibrium of the financial market is described by the Capital Market Line (CML) and the Security Market Line (SML). For every efficient portfolio, p, the CML states that

where rf is the risk-free interest rate, p is the expected return on the portfolio, M is the expected return on the market portfolio, and σM the standard deviation of the return on the market portfolio. The SML applies to individual assets and requires that, in equilibrium, the expected return on asset i satisfies

i = rf + βi[Mrf]

The beta coefficient of asset i, βi, is interpreted as a measure of the riskiness of the asset and is defined by , where σiM is the covariance of the return on asset i and the return on the market portfolio.

Subjects: Economics.

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