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This model was presented by Nobel Prize winner William Sharpe in 1964 and has
since been considered as an appropriate method of pricing assets based on risk
they carry and return they can generate. Sharpe’s work can be viewed as
basically an extension of Markowitz’s Portfolio theory, which identified that risk,
calculated as standard deviation of returns, can be minimized by diversifying
investments i.e. forming a portfolio of assets.
Unsystematic Risk
CAPM argues that diversifying your investment can reduce risk but it cannot be
eliminated fully. This is because by forming a portfolio (of different shares) only
one type of risk can be eliminated, that which is particular to circumstances of a
company and is known as Unsystematic Risk. For example, decline in returns on
Tesco due to fall in quarterly profits, due to fall in demand for company products,
a lawsuit, equipment failure or wasteful research and development program or a
rise in return due to appointment of a reputable chief Executive, rise in profits
due to lower costs etc.
Systematic Risk
For example; If Barclays has a β of 1.11 then when the market index return rises
by 10% Barclays return will rise by 11.1% and fall by 11.1% when FTSE return
falls by 10%. Shares with β of less than 1 will vary less than the market.
For a diversified investor the only risk is therefore β. Where Portfolio theory
studied the relation of return to overall risk of portfolio (measured by correlation
coefficient), CAPM studied the relation of returns to overall risk of the market
(measured by β). Hence we completed our journey from Capital market line
suggested by Portfolio theory to security market line, suggested by CAPM.
Expected Return
Security Market Line
Criticism of CAPM:
• Market indices employed such as FTSE 100 are poor substitutes for real
market portfolios.
• Beta is calculated at one point in time, after which risk free rate might
change.
• Unrealistic assumptions
o No taxes