The capital asset pricing model (CAPM) theory assumes that an investor expects a yield on a certain security equivalent to the risk free rate (say that rate achievable on six-month Treasury bill) plus a premium based on market variability of return X, a market risk premium. Over the past decade, the market risk premium on listed U.S. common stocks appears to have been about 6.5%, according to statistics published in the Quarterly Review by the Federal Reserve Bank of New York (1991) (though the Ibbotson study found it to exceed 8% from the mid-1920s through 1987). Therefore, in a period of 4% inflation, the T-bill rate might be appropriately 4.5 to 5%; a four or five year Treasury note should have a yield of 5.5 to 6%; Treasury bonds should yield a percent higher than this; and corporate bond yields should have even higher returns to compensate for their additional credit or business risk. .
The expected rate of return on any asset can be written as the risk-free rate of interest plus the asset's level of volatility relative to the market times the difference between market's expected rate of return and the risk-free rate. This model and the pricing result became known as the capital asset-pricing model (CAPM). For the first time finance theory created a simple model relating asset returns that could (in principle) be tested with econometric methods.
The second major contribution grew out of dissatisfaction with empirical tests of the CAPM. Although initial testing of CAPM appeared to show that the theory provided good fits to the data, subsequent work showed that the predictive power of CAPM was exaggerated by the test methodology. Arbitrage Pricing Theory (APT) was introduced as a generalized competitor to CAPM. By combining pure arbitrage and diversification arguments, Steve Ross (creator of APT) showed that one could obtain asset prices as a linear function of a few basic factors. Potentially, the model appeared stronger and more flexible than CAPM, and possibly immune to the testing problems associated with CAPM.
