Capital Asset Pricing Model

Financial markets build regulated structures whose role is to provide market participants with continuous liquidity among others. By nature, they are composed of dependent elements, which have to conform to the prevailing regulation for stability prospects. Therefore, the financial flows resulting from such markets are mutually dependent to some extent. Here is the cornerstone underlying the seminal theory proposed by William Sharpe (1963, 1964) with the capital asset pricing model (CAPM). A nonnegligible portion of financial asset prices results then from the broad market trend, namely, the propensity of security prices to move together and at the same time. The complementary part or residual part of financial asset prices depends consequently on the specific features peculiar to each financial asset or, at least, to each financial asset class a security can belong to. Of course, the residual part of asset prices is totally different and independent from the broad market trend. This setting yields William Sharpe to propose a model pricing the expected asset return as a function of the risk-free rate, the expected market risk premium, and the strength of the link prevailing between the asset return and the broad market return as represented by the market portfolio.