The Capital Asset Pricing Model is the keystone of the academic Modern Portfolio Theory developed in the Fifties and Sixties.  Its leading lights, Harry Markowitz, William Sharpe and Merton MIller, received the Nobel Prize in Economics for their role in developing this theory.

Taking a very simple view, the main difference between the CAPM and what I described in my Alpha and Beta post is the explicit introduction of a “risk-free” asset, normally thought of as being treasury bills.

Here’s the Alpha and Beta equation:

stock return = α + β(index return) + ε,

where α is a constant, β is the multiplier that links stock return and market return, and ε is a random error term.  (Although the theory doesn’t require it, the “index” has typically been interpreted as a stock market index, like the S&P 500.)

If we argue that the stock return has two components, the risk-free return (rf)  + the return for taking risk, then the equation can be rewritten as:

stock return = rf + α + β(index return – rf) + ε,

where β (a slightly different β from the first equation, but the same general idea) is a measure of the volatility of a stock vs the market, and α (a different α, sometimes called Jensen’s alpha) is any return that remains, positive or negative. Continue reading →