individual securities. The theory asserts not only that such a relationship exists, but also
that it has a very simple form which we shall now state.
According to MPT, a part of the return on any security or portfolio is a reward for risk
and the rest is the reward for waiting, representing the time value of money. Specifically,
the risk-free return (which is earned by a security which has no risk) is the reward for
waiting and the excess of the return over the risk-free return is the risk premium or the
reward for risk. The Modern Portfolio Theory asserts that the risk premium of any
security is directly proportionate to the risk as measured by the Beta:
Risk Premium of a Security = Beta X Risk premium of market
Where
Risk premium of a security is the excess of the expected security return over the
risk-free rate of return, and
Risk premium of market is the excess of the expected market return over the risk-
free rate of return.The above relationship can also be expressed as:
Expected return on security = Risk-free return + Beta X Risk
Premium of market.
The above relationship, which is basically a simple linear relationship between risk and
return, is known as the Capital Asset Pricing Model (CAPM). The credit for developing
the arguments leading to the model goes to Sharpe, Linter and Mossin. The first author
of the model was also one of the three who shared the Nobel Prize for Economics in 1990
for the work. While CAPM is valid for all capital assets, in this chapter we have mostly
used the term ‘securities’ since in this book securities are what we are primarily
concerned with.