Encyclopedia of Financial Models, 3 Volume Set

Capital Asset Pricing Models

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

HARRY M. MARKOWITZ, PhD

Consultant

Abstract: Risk-return analysis in finance is a “normative” theory: It does not purport to describe, rather it offers advice. Specifically, it offers advice to an investor regarding how to manage a portfolio of securities. The investor may be an institution, such as a pension fund or endowment; or it may be an asset management firm with multiple portfolios to manage (e.g., managing various mutual funds and funds for institutional clients). The focus of risk-return analysis is on advice for each individual portfolio. This contrasts with capital asset pricing models, which are hypotheses concerning capital markets as a whole. They are “positive” models, that is, they are hypotheses about that which is—as opposed to “normative” models, which advise on what should be or, more precisely, advise on what an investor should do.

INTRODUCTION

Asset pricing theory seeks to explain how the price or value of a claim from ownership of a financial asset is determined. The pricing or valuation of an asset must take into account the timing of the payments expected to be received and the risk associated with receiving the expected payments. The major challenge in asset pricing theory is often not the timing issue but the treatment of risk. The formulation of an asset pricing theory that has empirically proven to have good predictive value offers investors ...