The Capital Asset Pricing Model
On the supply of funds side, burgeoning pools of private investment capital inside pension funds and insurance companies cried out for scientific management, and portfolio theory developed to meet that demand.
By treating the returns on individual securities as random variables, Markowitz (1952) was able to provide a framework for thinking about efficient portfolio diversification, and for actually calculating the portfolio weights that would achieve minimum risk for any given expected return target. (See also Roy 1952, writing outside the US.)On the demand for funds side, increased scarcity of investment funds inside corporations forced new attention to focus on capital allocation decisions, as well as on decisions about external funding in capital markets; corporate finance theory developed to guide these decisions. By abstracting from taxation and bankruptcy, Modigliani and Miller (1958) were able to provide a framework for thinking systematically about the problem of the appropriate capital structure of a firm, a framework that clarified not only the choice between debt and equity finance, but also the choice between internal and external funding.
These two different material origins of modern finance help to explain the different versions of the capital asset pricing model (CAPM) that emerged at more or less the same time, as well as the mutual incomprehension with which they initially received one another. Bill Sharpe’s (1964) CAPM built on the portfolio theory pioneered by Harry Markowitz, as did the CAPM of Jan Mossin (1966). By contrast, the CAPMs of Jack Treynor (1962) and John Lintner (1965) both built on the corporate finance theory pioneered by Franco Modigliani and Merton Miller. The eventual 1990 Nobel prize (the
Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) that recognized these achievements was shared by Markowitz, Sharpe and Miller, thus recognizing both versions, and hence both origins.
Nevertheless, for teaching purposes, the canonical CAPM became that of Sharpe, which made its way into textbooks as the following formula:
This says that the expected return on asset i is equal to the risk-free rate of interest Rf plus the amount of risk in the asset βi times the price of risk. According to CAPM, portfolio diversification implies that risk is properly measured by the covariance of an asset with the diversified market portfolio (not by the asset’s own variance), and that the price of risk is the excess expected return on that diversified market portfolio, (ERm - Rf).
The two origins shared the CAPM Nobel prize, but that prize did not come for 25 years, a delay that in retrospect can be understood as reflecting the time it took for the new finance to be recognized as a contribution to economics proper. To most economists, CAPM just did not seem that important; it was about private finance not public finance, and also about finance not money. At the beginning, the new finance entered economics only to the extent that it seemed to bear on the traditional fiscal and monetary policy concerns of economics.
Thus, Sharpe was not initially seen as the main road leading from Markowitz; first there was Tobin (1969) whose contributions to portfolio theory fed directly into the economists’ project of building large-scale econometric models of the economy, the better to calibrate fiscal and monetary policy interventions. Similarly, Lintner and Treynor were not the main road leading from Modigliani and Miller; first there was Ando and Modigliani (1969) whose “Econometric analysis of stabilization policies” actually implemented the necessary parameterization. Thus Tobin and Modigliani got their Nobel prizes first, in 1981 and 1985, respectively. Initially, the work of Tobin and Modigliani was considered finance enough for economics.