Don U.A.Galagedera*

Department of Econometrics and Business Statistics

Monash University

PO Box 197 Caulfield East

Victoria 3145 Australia

Abstract

This paper provides a review of the main features of asset pricing models. The

review includes single-factor and multifactor models, extended forms of the

1. Introduction

The foundations for the development of asset pricing models were laid by Markowitz (1952)

and Tobin (1958). Early theories suggested that the risk of an individual security is the

standard deviation of its returns – a measure of return volatility. Thus, the larger the standard

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expected to select a portfolio, which is most appropriate for them, from the efficient set of

portfolios available to them.

The computation of risk reduction as proposed by Markowitz is tedious. Sharpe (1964)

developed a computationally efficient method, the single index model, where return on an

individual security is related to the return on a common index. The common index may be any

variable thought to be the dominant influence on stock returns and need not be a stock index

(Jones, 1991). The single index model can be extended to portfolios as well. This is possible

because the expected return on a portfolio is a weighted average of the expected returns on

individual securities.

When analysing the risk of an individual security, however, the individual security risk must

be considered in relation to other securities in the portfolio. In particular, the risk of an

individual security must be measured in terms of the extent to which it adds risk to the

investor’s portfolio. Thus, a security’s contribution to portfolio risk is different from the risk

of the individual security.

Investors face two kinds of risks, namely, diversifiable (unsystematic) and non-diversifiable

(systematic). Unsystematic risk is the component of the portfolio risk that can be eliminated

by increasing the portfolio size, the reason being that risks that are specific to an individual

security such as business or financial risk can be eliminated by constructing a well-diversified

portfolio. Systematic risk is associated with overall movements in the general market or

economy and therefore is often referred to as the market risk. The market risk is the

component of the total risk that cannot be eliminated through portfolio diversification.

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The CAPM developed by Sharpe (1964) and Lintner (1965), discussed in the following

section, relates the expected rate of return of an individual security to a measure of its

systematic risk. Since then, a variety of models have been developed to predict asset returns.

These are discussed in Section 3. A brief summary is given in Section 4.

2 The capital asset pricing model

The CAPM conveys the notion that securities are priced so that the expected returns will

compensate investors for the expected risks. There are two fundamental relationships: the

capital market line and the security market line. These two models are the building blocks for

deriving the CAPM. Even though they are not new, it is illustrative to discuss them here

a portfolio. This is a linear relationship between risk and return on efficient portfolios that can