William Sharpe, a guest on the Aug. 23 program, was one of three men awarded the 1990 Nobel Prize for Economics. Sharpe initially made his reputation in the 1960s when he built on the work of Harry Markowitz, a co-recipient of the 1990 award. Following is an excerpt of the Nobel committee's citation:
Nobel citation: The Capital Asset Pricing Model
With the formulation of the so-called Capital Asset Pricing Model, or CAPM, which used Markowitz's model as a "positive" (explanatory) theory, the step was taken from micro analysis to market analysis of price formation for financial assets. In the mid-1960s, several researchers -- independently of one another -- contributed to this development. William Sharpe's pioneering achievement in this field was contained in his essay entitled, "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk" (1964).
The basis of the CAPM is that an individual investor can choose exposure to risk through a combination of lending-borrowing and a suitably composed (optimal) portfolio of risky securities. According to the CAPM, the composition of this optimal risk portfolio depends on the investor's assessment of the future prospects of different securities, and not on the investors' own attitudes towards risk. The latter is reflected solely in the choice of a combination of a risk portfolio and risk-free investment (for instance treasury bills) or borrowing. In the case of an investor who does not have any special information, i.e., better information than other investors, there is no reason to hold a different portfolio of shares than other investors, i.e., a so-called market portfolio of shares
What is known as the "beta value" of a specific share indicates its marginal contribution to the risk of the entire market portfolio of risky securities. Shares with a beta coefficient greater than 1 have an above-average effect on the risk of the aggregate portfolio, whereas shares with a beta coefficient of less than 1 have a lower than average effect on the risk of the aggregate portfolio. According to the CAPM, in an efficient capital market, the risk premium and thus also the expected return on an asset, will vary in direct proportion to the beta value. These relations are generated by equilibrium price formation on efficient capital markets.
An important result is that the expected return on an asset is determined by the beta coefficient on the asset, which also measures the covariance between the return on the asset and the return on the market portfolio. The CAPM shows that risks can be shifted to the capital market, where risks can be bought, sold and evaluated. In this way, the prices of risky assets are adjusted so that portfolio decisions become consistent.
The CAPM is considered the backbone of modern price theory for financial markets. It is also widely used in empirical analysis, so that the abundance of financial statistical data can be utilized systematically and efficiently. Moreover, the model is applied extensively in practical research and has thus become an important basis for decision-making in different areas. This is related to the fact that such studies require information about firms' costs of capital, where the risk premium is an essential component. Risk premiums which are specific to an industry can thus be determined using information on the beta value of the industry in question.
Important examples of areas where the CAPM and its beta coefficients are used routinely, include calculations of costs of capital associated with investment and takeover decisions (in order to arrive at a discount factor); estimates of costs of capital as a basis for pricing in regulated public utilities; and judicial inquiries related to court decisions regarding compensation to expropriated firms whose shares are not listed on the stock market. The CAPM is also applied in comparative analyses of the success of different investors.
Along with Markowitz' portfolio model, the CAPM has also become the framework in textbooks on financial economics throughout the world.