Capital Asset Pricing Model

The first type of model explaining asset prices uses economic considerations. Using the results of the portfolio selection presented in the previous chapter, the Capital Asset Pricing Model (CAPM) gives an answer to the question asking what can be said of the market by aggregating the rational investors' decisions and, also, by what assumption the equilibrium would evolve. Sharpe (1964) and Lintner (1965) prove the existence of the equilibrium subject to the following assumptions:

• Individual investors are price takers

• Single-period investment horizon

• Investments are limited to traded financial assets

• No taxes and no transaction costs

• Information is costless and available to all investors

• Investors are rational mean-variance optimizers

• Homogenous expectations

In a world where these assumptions are held, all investors will hold the same portfolio of risky assets, which is the market portfolio. The market portfolio contains all securities and the proportion of each security...