Models of asset pricing describe expected rates of return of
financial assets which are traded in financial markets. Financial assets are
things like bonds, options, future contract etc. These models of financial
economics are based on two core concepts. The first one is “no arbitrage
principle” and the second one is “financial market equilibrium”.

The “no arbitrage principle” states that market forces tend to
align the prices of financial assets so as to eliminate arbitrage
opportunities. This implies there is no such financial asset with zero cost.

The second one is “financial market equilibrium”, condition for
financial market equilibrium in a market with no frictions is that the
first-order conditions of the investor’s optimization problem are satisfied
because Investors’ desired holdings of financial assets are derived from an
optimization problem.

### Capital Asset Pricing Model (CAPM)

Of the various model of asset pricing, one of the models is the
Capital Asset Pricing Model (CAPM). CAPM calculates a required return based on
a risk measurement. To do this, the model relies on a risk multiplier called
the beta coefficient.

CAPM
depends on certain assumptions. Originally, there were nine assumptions,
although more recent work in financial theory has relaxed these rules somewhat.
The original assumptions were:

- Investors
are wealth maximizers, who select investments based on expected return and
standard deviation.
- Investors
can borrow or lend unlimited amounts at a risk-free (or zero risk) rate.
- There
are no restrictions on short sales (selling securities that you don't yet
own) of any financial asset.
- All
investors have the same expectations related to the market.
- All
financial assets are fully divisible (you can buy and sell as much or as
little as you like) and can be sold at any time at the market price.
- There
are no transaction costs.
- There
are no taxes.
- No
investor's activities can influence market prices.
- The
quantities of all financial assets are given and fixed.

The CAPM formula is
sometimes called the Security Market Line formula and consists of the following
equation:

**r* = kRF + b(kM - kRF)**

It is basically the
equation of a line, where:

r* = required return

kRF = the risk-free
rate

kM = the average
market return

b = the beta
coefficient of the security (risk attached to the investment)

Simply, the required return will be positively correlated to the risk
attached to the investment (b). If risk attached to the investment is greater
than that with the market risk than high return is desirable and if the risk
attached to the investment is less than that with the market rate then return
below the market rate can be acceptable.

The main assumption of this model is such that investors are well
diversified with several market portfolios which eliminate the unsystematic
part of the whole risk. The only risk left is the systematic risk which is a
risk which affects the whole economic environment as a whole, in a modern world
there are some techniques developed to minimize the systematic risk but
generally it affects the whole economy.

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