The capital asset pricing model

At the heart of any pricing model is the challenge of measuring value. This problem is applicable to the price of a company's stock, the value of a potential acquisition, or any other asset that may require valuation. The term "value" is generally given to mean the fair price that an investor would be willing to pay for a firm, a portion of a firm, or any other asset, and it is determined by three factors: the size of the anticipated return, the date that these returns will be received, and the risk that the investor takes to obtain the returns (Lewellen & Ang, 1982, p. 113).

Of these three factors, risk is generally the most difficult to measure and to incorporate into

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returns are also the weighted average of the expected returns from the assets in the portfolio. For assets with risk, investors expect the risk-free rate of return plus extra compensation for the systematic risk of the asset. This extra compensation is called the market price of risk. For the average asset, the market price of risk is the difference between the risk-free rate of return and the return from the market (Herbst, 1990, p. 255.). The CAPM differs from the traditional risk-premium model in that it measures risk in a particular way and in doing so, requires very explicit assumptions. These assumptions are the basis for the controversy that surround the CAPM. There are eight assumptions that underlie the CAPM; the first five deal with the efficient-market hypothesis and the last three are necessary to derive the CAPM from the MPT (Harrington, 1987, p. 26): 1. The investor's objective is to maximize the utility of terminal wealth. 2. Investors make choices on the basis of risk and return. Return is measured by the mean returns expected from a portfolio of assets; risk is measured by the variance of these portfolio returns. 3. Investors have homogeneous expectations of risk and return. 4. Investors have identi
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