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The capital asset pricing model (CAPM) is a formula used to determine the value relationship between risk premium and expected return for a capital asset. It is essential for assessing the feasibility of investing in shares and determining the systemic or market risk of an investment. Several economists contributed to its development, and Markowitz, Sharpe, and Miller were jointly awarded the Nobel Prize in Economics for their work.
Sometimes referred to as CAPM, the capital asset pricing model is a formula process used to describe the value relationship between the risk premium and the expected return associated with a capital asset. The calculation of the capital asset pricing model helps establish the relationship between the cost of manufacturing a product for sale and the unit cost that must be realized to obtain a return on the process.
Understanding the capital asset pricing model is also essential in assessing the feasibility of investing in shares issued by a given company. By valuing stocks in this manner, an investor is able to determine how much risk is associated with the investment, as well as get an idea of what type of return can reasonably be anticipated from the company 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 needed to project the outcome of adding the stock to the investment portfolio. An accurate assessment of this non-diversifiable risk, along with the anticipated return, is essential to the process of arriving at a usable valuation that will help the investor make an informed decision.
Several different economists independently pursued the development of the concept that eventually became known as the capital asset pricing model. Much of the work was based on the thoughts of Harry Markowitz, who was considered an authority on modern portfolio theory, including the idea of diversification strategies within a portfolio to maximize overall value. Other economists who added valuable contributions to the task included Jack Treynor, John Lintner, William Sharpe, Merton Miller, and Jan Mossin. Over time, several of these experts formulated ideas that were so close in form and application that it was inevitable that their work would be combined. As a result, Markowitz, Sharpe, and Miller were jointly awarded the Nobel Prize in Economics for their work in developing the capital asset pricing model and their contributions to the study of financial economics in general.
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