An Introduction to

Asset
Pricing Models
Capital market theory is a generic term for
the analysis of securities. In terms of trade
off between the returns sought by investors
and the inherent risks involved, the capital
market theory is a model that seeks to price
assets, most commonly, shares..
Because capital market theory builds on the
Markowitz portfolio model, it requires the
same assumptions, along with some
additional ones:
•All investors are Markowitz-efficient in that they
seek to invest in tangent points on the efficient
frontier.
•Investors can borrow or lend any amount of money
at the risk-free rate of return (RFR).
•All investors have homogeneous expectations;
that is, they estimate identical probability
distributions for future rates of return.
•All investors have the same one-period time
horizon, such as one month or one year.
•There are no taxes or transaction costs involved in
buying or selling assets.
•There is no inflation or any change in interest
rates,
Some of these assumptions may seem
unrealistic, but keep in mind two things.
First, as mentioned, relaxing them would
have only a minor effect on the model and
would not change its main implications or
conclusions. Second, a theory should never
be judged on the basis of its assumptions
but rather on how well it explains and helps
us predict behavior in the real world.
If this theory and the model it implies help
us explain the rates of return on a wide
variety of risky assets, it is useful, even if
some of its assumptions are unrealistic.
The major factor that allowed Markowitz
portfolio theory to develop into capital
market theory is the concept of a risk-free
asset, that is, an asset with zero variance.
As we will show, such an asset would have
zero correlation with all other risky assets
and would provide the risk-free rate of
return (RFR).
This assumption of a risk-free asset allows us to derive a
generalized theory of capital asset pricing under conditions
of uncertainty from the portfolio theory. This achievement is
generally attributed to William Sharpe (1964), who received
a Nobel Prize for it.
The capital asset pricing model (CAPM)
helps to calculate investment risk and what
return on investment an investor should
expect.
His model starts with the idea that individual
investment contains two types of risk:
Systematic Risk – These are market risks—that is, general
perils of investing—that cannot be diversified away. Interest
rates, recessions, and wars are examples of systematic risks.
Unsystematic Risk – Also known as "specific risk," this risk
relates to individual stocks. In more technical terms, it
represents the component of a stock's return that is not
correlated with general market moves.
 An Introduction to Asset
Pricing Models and YouTube
Video Link for more
understanding as
reference
https://www.youtube.com/
watch?v=_Ws4YJGe0VE&t=2
49s
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