Maryland English Institute 1
The Extended Definition
The Extended Definition
Boyang Li
UID:112537777
Term: CAPM
If you have ever wondered why investment banks such as Goldman Sachs and Merrill
Lynch usually have much higher return rate in the market than normal private investors,
or how prices of stocks and bonds listed in NYSE and NASDAQ are decided, you will
probably interested in what we are going to talk about in this text ----- the CAPM.
CAPM is an abbreviation for the financial term “Capital Asset Pricing Model”, which is a
pricing model initially developed in 1952 by Harry Markowitz. The model was then
constantly improved by other experts and became renowned in the financial field over
decades, which led to Markowitz’s won in the 1990’s Nobel Economics Prize.
CAPM provides us with an efficient way to determine the proper price of a security or an
asset with risk. The general idea of the CAPM model is that when an investor choose to
invest in a security with risk, he or she will require the security to provide a higher return
rate than that of a riskless security. The difference between the security’s return rate and
the risk-free return rate is called risk premium. Thus, the required return rate of a security
will equal to the sum of the risk free rate and the risk premium of the security, in which
the latter one is decided by the risk level of the industry the company is operating in in
general, and the company’s business condition in particular. However, as you may doubt,
it is hard for us to get a precise risk premium for every security in the market using the
limited public information we can get. Fortunately, CAPM model provides us with a new
way of thinking that is proved to be correct and efficient, and that is the true contribution
of the CAPM model to the modern finance industry.
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When we think about what information we can get from the open market, the most
accurate and reliable one we can get is the historical data. From this point, Markowitz
calculated the average return rate of all the securities listed in the market for a certain
period, and got their averaged return rate called the market rate. He then calculated the
related coefficient of some singular securities’ return rates with the market rate, and
named the related coefficient “Beta”. The beta value of a single security reflects the
differences between the price change tendency of the single security and the market as a
whole. Thus, the CAPM model changes to the following: Return rate of security A =
Risk-free rate + Beta of A*(Market rate – Risk-free rate). As we have very specific
historical data of the price change of all the securities in the market and the risk-free rate
(It basically equals to the return rate of the treasury bond issued by the government as it
is regarded as riskless), we can now calculate every singular security’s target price from
next minute to the next year using different length of historical data.
As long as the market is steady, the price of a security will be close to and fluctuates
around the price we get from the CAPM model. By using this model and other tools to
monitor the price of every security in the market, investment banks can find securities
with the wrong price, and thus make money by buy or short-sell them.