Investments: Analysis and Management, 12th Edition

chapter 9

Capital Market Theory and Asset Pricing Models

Although you have postponed dealing with the issue, in the back of your mind you remember from your finance course a well known model called the CAPM. It occurs to you that this model, which was said to be so important in finance, probably has a role to play in your investing decisions. And in fact it does because it captures the concept of a required rate of return for a stock, which is important to consider when you are trying to decide which stocks to buy. So the time has come to bite the bullet and review some theory regarding asset prices and markets, and consider the CAPM once again. Knowing about the required rate of return will be important when you start trying to value common stocks, a topic that you are almost ready to tackle. Furthermore, understanding how risk is priced in financial markets can be very valuable to an investor.

In the last chapter we discussed portfolio theory, which is normative, describing how investors should act in selecting an optimal portfolio of risky securities. In this chapter we consider theories about asset pricing. What happens if all investors seek portfolios of risky securities using the Markowitz framework under idealized conditions? How will this affect equilibrium security prices and returns? In other words, how does optimal diversification affect the market prices of securities? Under these idealized conditions, what is the risk-return tradeoff that investors face? In general, ...