The Capital Asset Pricing Model: An Overview of the Theory

  •  Mona Elbannan    


Although the Capital Asset Pricing Model (CAPM) has been one of the most useful and frequently used theories in determining the required rate of return of a security, the application of this model has been controversial since early 1960s. The CAPM was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. In theory, the capital asset pricing model is employed to set the investor required rate of return on a risky security given the non-diversifiable firm-specific risk, as the systematic risk will be eliminated in a well-diversified portfolio. This research aims to shed the light on this model by discussing the assumptions, the evolution of the Sharpe and Lintner model, and reviewing the literature on the relaxation of model assumptions and the critiques of the CAPM. Finally, the Arbitrage Pricing Model as an extension for the CAPM will be discussed.

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