The Mathematics of Financial Modelingand Investment Management

17-Capital Asset Pricing Model Page 526 Wednesday, February 4, 2004 1:10 PM

526 The Mathematics of Financial Modeling and Investment Management

notes: “These ideas play an important role in the methods of ‘modern

portfolio theory.’”

In the next chapter we will discuss another asset pricing model that

introduces risk factors other than market risk. Earlier in this chapter we

also discussed other models that consider nonmarket risk factors. How-

ever, these do not invalidate the important constructs developed by the

CAPM. Rosenberg concludes his article with the following statement:

The question of rewards for factors other than equity mar-

ket risk has been the subject of active study and contro-

versy for a decade—and no doubt will continue to be so in

the decades to come. Nevertheless, no one has refuted the

existence of equilibrium reward for equity market risk;

indeed, it has rarely been questioned, although the magni-

tude has been in doubt. The concept of reward to equity

market risk (or beta) is a theoretical insight, that, in my

view, is likely to endure. (p. 16).

Fast forward a little more than two decades since the publication of the

Rosenberg article and his conclusions still hold.^21

Moreover, Markowitz has explained that the major reason for the

debate is the confusion between the beta that is associated with the mar-

ket model (estimated to avoid having to compute all covariances for

assets in a portfolio) and the beta in the CAPM, a point we emphasized

in the previous section.^22

SUMMARY

■ The Capital Asset Pricing Model (CAPM) is a general equilibrium the-

ory based on the assumption that investors are rational and subscribe

to the Markowitz mean-variance framework.

■ A key finding of the CAPM is that, in a situation of equilibrium

between demand and supply, if agents optimize in the sense of mean-

(^21) These sentiments were echoed in a presentation by Peter Bernstein in a keynote ad-
dress on the occasion of the fifth anniversary of the establishment of the Internation-
al Center for Financial Management & Engineering (FAME) in Geneva on February
7, 2002. (See “How Modern is Modern Portfolio Theory?” Economics and Portfolio
Strategy, Peter L. Bernstein, Inc., March 15, 2002.)
(^22) Harry M. Markowitz, “The ‘Two Beta’ Trap,” The Journal of Portfolio Manage-
ment (Fall 1984), pp. 12–20.