Handbook of Finance: Investment Management and Financial Management

Chapter 2. Asset Pricing Models

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Abstract: In portfolio management, a key input in portfolio construction is the expected return for an asset. In corporate financial management, computing a firm's cost of capital requires that the cost of equity be computed. The cost of equity is the expected return that investors require from investing in a corporation's common stock. Asset pricing models describe the relationship between the risks of a security and the expected return. The two most well-known equilibrium pricing models are the capital asset pricing model developed in the 1960s and the arbitrage pricing theory model developed in the mid 1970s. Other asset pricing models are based on empirical factors that affect expected returns. These multifactor pricing models are classified as statistical factor models, macroeconomic factor models, and fundamental factor models.

Keywords: asset pricing model, risk factors, systematic risk factors, nondiversifiable risk factors, unsystematic risk factors, diversifiable risk factors, capital asset pricing model (CAPM), beta, capital market line (CML), market portfolio, security market line (SML), characteristic line, zero-beta portfolio, arbitrage pricing theory (APT) model, arbitrage principle, multifactor risk model, statistical factor model, macroeconomic factor model, fundamental factor model

The theory of portfolio selection as formulated in 1952 by ...