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What is the Capital Asset Pricing Model?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 09 November 2016
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    Conjecture Corporation
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Sometimes referred to as CAPM, the capital asset pricing model is a process of formula that is used to describe the value relationship between the risk premium and expected return involved with a capital asset. The calculation of the capital asset pricing model helps to establish the relationship between the cost of manufacturing a product for sale, and the unit cost that must be realized in order to realize a return on the process.

Understanding the capital asset pricing model is also essential to evaluating the viability of investing in stocks issued by a given company. By valuing stocks in this manner, it is possible for an investor to determine what degree of risk is associated with the investment, as well as get an idea of what type of return can reasonably anticipated from the venture within a given period of time. This is often referred to as the systemic or market risk of the investment, and is one of the key components necessary to project the outcome of adding the stock to the investment portfolio. An accurate assessment of this non-diversifiable risk, when coupled with the anticipated return, is essential to the process of arriving at a usable valuation that will help the investor make an informed decision.

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Several different economists independently pursued the development of the concept tat eventually came to be known as capital asset pricing model. Much of the work was based on the thoughts of Harry Markowitz, who was considered to be an authority on modern portfolio theory, including the idea of diversification strategies within a portfolio to maximize the overall value. Other economists who added valuable contributions to the task were Jack Treynor, John Lintner, William Sharpe, Merton Miller, and Jan Mossin. In time, several of these experts formulated ideas that were so close in form and application that it was inevitable their work would combine. As a result, Markowitz, Sharpe, and Miller jointly received the Nobel Memorial Prize in economics for their work in the development of the capital asset pricing model and their contributions to the study of financial economics in general.

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