The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CHAPTER 4

Capital Asset Pricing Models

Frank J. Fabozzi, Ph.D., CFA, CPA Professor in the Practice of Finance Yale School of Management

 

Harry M. Markowitz, Ph.D. Consultant

 

 

 

 

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 institution with multiple portfolios to manage, such as a Fidelity or Vanguard, which manage various mutual funds as well as funds for institutional clients. The focus of risk-return analysis is on advice for each individual portfolio.

This contrasts with capital asset pricing models (CAPMs), the focus of this chapter, 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.

Despite the importance of CAPMs in finance, there is considerable confusion regarding certain aspects of the theory. So, in addition to describing CAPMs in this chapter, we explain the sources of the confusion and their implications.