CAPM: THE PREFERRED PRICING MODEL
Capital Asset Pricing Model
The capital asset pricing model (CAPM) theory assumes that an investor expects a yield on a certain security equivalent to the risk free rate (say that rate achievable on six-month Treasury bill) plus a premium based on market variability of return X, a market risk premium. Over the past decade, the market risk premium on listed U.S. common stocks appears to have been about 6.5%, according to statistics published in the Quarterly Review by the Federal Reserve Bank of New York (1991) (though the Ibbotson study found it to exceed 8% from the mid-1920s through 1987). Therefore, in a period of 4% inflation, the T-bill rate might be appropriately 4.5 to 5%; a four or five year Treasury note should have a yield of 5.5 to 6%; Treasury bonds should yield a percent higher than this; and corporate bond yields should have even higher returns to compensate for their additional credit or business risk.
The expected rate of return on any asset can be written as the risk-free rate of interest plus the assets level of volatility relative to the market times the difference between markets expected rate of return and the risk-free
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