Capital Asset Pricing Model

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The 1990 Nobel Prize in Economic Science was awarded to three Americans who pioneered new tools for analyzing the risks and rewards of investments. Among the three was William F. Sharpe, who in the 1960s, as a faculty member in the UW business school, published a pathbreaking paper containing the findings and conclusions now known as the Capital Asset Pricing Model, for which he was awarded the Nobel.

The award not only recognized the achievements of Sharpe, Harry Markowitz of City College of New York, and Merton H. Miller of the University of Chicago; it also marked an historic milestone. As one expert in the field commented, the event signaled "the final seal of approval" for recognizing, for the first time, that finance was a major area of economics. The field of finance had been transformed from something of strictly institutional interest, without basic theories or models, into a new and flourishing field of study.

Theories advanced by the three during the 1950s and 1960s are widely applied today, influencing the decisions of bankers, brokers, government agencies, and millions of people who invest money. Their research explained how the weighing of risk and reward helps to determine securities prices; and how those prices depend on such factors as tax changes and bankruptcy risk. The theories are used by corporate finance officers to set company financial policies, by analysts to evaluate the performance of individual stocks and mutual funds, and by governments to assess the potential effects of changes in the tax structure on the economy.

Markowitz had focused on how investors use risk and reward assessments in forming portfolios. This research showed that diversification is generally required in obtaining the optimal tradeoff between risk and return. Sharpe built on that work and developed a model, called the Capital Asset Pricing Model, for explaining how markets incorporate risk in pricing securities. His theory is used by investment firms to predict, for example, how stocks will perform in relation to the market as a whole.

An outcome of Sharpe's work is the quantity widely used on Wall Street called "beta," a measure of asset and portfolio risk. The quantity relates the expected return on an asset or portfolio to the expected return on the market. Sharpe's work suggests that the expected return on a portfolio should increase proportionally with beta. For example, if a mutual fund has a beta of 1.5 and the expected return on the market increases by 10 percent, then the expected return on the mutual fund will increase by 15 percent.

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