Editing Capital asset pricing model (section)

{{Short description|Model used in finance}}
{{More citations needed|date=April 2021}}
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[[File:CAPM-SML.svg|thumb|274px|An estimation of the CAPM and the security market line (purple) for the [[Dow Jones Industrial Average]] over 3 years for monthly data.]]
In [[finance]], the '''capital asset pricing model''' ('''CAPM''') is a model used to determine a theoretically appropriate required [[rate of return]] of an [[asset]], to make decisions about adding assets to a [[Diversification (finance)|well-diversified]] [[Portfolio (finance)|portfolio]].

The model takes into account the asset's sensitivity to non-diversifiable risk (also known as [[systematic risk]] or [[market risk]]), often represented by the quantity [[Beta (finance)|beta]] (β) in the financial industry, as well as the [[expected return]] of the market and the expected return of a theoretical [[Risk-free bond|risk-free asset]]. CAPM assumes a particular form of utility functions (in which only first and second [[Moment (mathematics)|moments]] matter, that is risk is measured by variance, for example a quadratic utility) or alternatively asset returns whose probability distributions are completely described by the first two moments (for example, the [[normal distribution]]) and zero transaction costs (necessary for diversification to get rid of all idiosyncratic risk). Under these conditions, CAPM shows that the cost of equity capital is determined only by beta.<ref name="p293">{{cite journal |last=Sharpe |first=William F. |title=Capital Asset Prices with and without Negative Holdings |journal=The Journal of Finance |publisher=[American Finance Association, Wiley] |volume=46 |issue=2 |year=1991 |issn=00221082 |jstor=2328833 |pages=489–509 |url=http://www.jstor.org/stable/2328833}}</ref><ref name="Chong">{{cite web|title=The Entrepreneur's Cost of Capital: Incorporating Downside Risk in the Buildup Method|url=http://www.macrorisk.com/wp-content/uploads/2013/04/MRA-WP-2013-e.pdf|access-date=25 June 2013|author-first1=James |author-last1=Chong|author-first2=Yanbo |author-last2=Jin |author-first3=Michael |author-last3=Phillips |date=April 29, 2013}}</ref> Despite its failing numerous empirical tests,<ref name="FamaFrench2004">{{cite journal |last1=Fama |first1=Eugene F |last2=French |first2=Kenneth R |date=Summer 2004 |title=The Capital Asset Pricing Model: Theory and Evidence |journal=Journal of Economic Perspectives |volume=18 |issue=3 |pages=25–46 |doi=10.1257/0895330042162430|doi-access=free }}</ref> and the existence of more modern approaches to asset pricing and portfolio selection (such as [[arbitrage pricing theory]] and [[Merton's portfolio problem]]), the CAPM still remains popular due to its simplicity and utility in a variety of situations.