Modern Portfolio Theory: Foundations, Analysis, and New Developments, + Website

Chapter 12

The Capital Asset Pricing Model

After Markowitz developed the two-parameter portfolio analysis model, researchers began investigating the stock market implications that would occur if all investors used the Markowitz two-parameter model to make their investment decisions.¹ As a result of these investigations, what is referred to as the capital asset pricing model (CAPM) was developed. The CAPM is also called the security market line (SML). This Nobel prize–winning theory is not the only theory that could be called a capital market theory, but for the purposes of this chapter we will refer to it as such. A similar but different capital market theory that takes place in continuous time will be presented in Chapter 14.

12.1 Underlying Assumptions

Capital market theory is based on the assumptions underlying portfolio analysis, because the theory is essentially an accumulation of the logical implications of portfolio analysis. The initial portfolio theory assumptions are:

1. Investors in capital assets (defined as all terminal-wealth-producing assets) are risk-averse one-period expected-utility-of-terminal-wealth maximizers. Equivalently, investors are risk averse and maximize their expected utility of returns over a one-period planning horizon.

2. Investors find it possible to make their portfolio decisions solely on the basis of the mean and standard deviation of the terminal wealth (or, equivalently, rates of return) associated with the alternative portfolios.

3. The ...