By William F. Sharpe

Abstract

The article discusses a model of capital assets pricing that can be used to predict market behavior with risk as a factor in the analysis. A graph is shown that depicts how the risk that investors are willing to take can impact the expected return. When managing a portfolio, investors are likely to choose investments on the basis of the expected value that will increase their personal wealth and the standard deviation. The article concludes that investors will settle for a modest rate of return on defensive securities than they would expect from more aggressive kinds of investments..

From the Introduction

One of the problems which has plagued those attempting to predict the bahvior of capital markets is the absence of a body of positive microeconomic theory dealing with conditions of risk. Although many useful insights can be obtained from the traditional models of investment under conditions of uncertainty, the pervasive influence of risk in financial trasactions has forced those working in this area to adopt models of price behavior which are little more than assertions. A typical classroom explanation of the determination of capital asset prices, for example, usually begins with a careful and relatively rigorous description of the process through which individual preferences and physical relationships interact to determine an equilibrium pure interest rate. This is generally followed by an assertion that somehow a market risk-premium is also determined, with the prices of assets adjusting accordingly to account for differences in their risk.