CAPITAL ASSET PRICING MODEL (CAPM)
The capital asset pricing model (CAPM),as the name suggests, is a theory that explains how asset prices are form~ in the market place. II is a logical and major extension of the portfolio theory of Markowitz by William Sharpe (964),9 John Lintner (1964)0 and Jan Mossin (1967)11.
The capital asset pricing model provides the framework for determining the equilibrium expired return for risky assets. It uses the results of capital market theory to derive the relationship between expected return and systematic risk of individual assets/securities and portfolios. Capital market theories, also referred to as asset pricing the ones, deal with how prices are determined if investors behaved the way Markowitz's portfolio theory suggests, price reflects the expected return and risk associated with an asset. Thus, the CAPM has carnations for:
(a) Risk-return relationship for an efficient portfolio
(b) Risk-return relationship for an individual asset security.
(c) Identification of under and over- valued assets traded in the market
(d) Pricing of asset' not yet traded in the market
(e) Effect of average on cost of equity (rate of return required by equity shareholders)
(f) Capital budgeting decisions and cost of capital
(g) Risk of the firm through diversification of project portfolio