International Journal of Economics and Finance; Vol. 7, No. 1; 2015 ISSN 1916-971X E-ISSN 1916-9728 Published by Canadian Center of Science and Education 216 The Capital Asset Pricing Model: An Overview of the Theory Mona A. Elbannan 1 1 Faculty of Management Technology, German University in Cairo, Cairo, Egypt Correspondence: Mona A. Elbannan, Faculty of Management Technology, German University in Cairo, New Cairo City 11835, Cairo, Egypt. Tel: 20-2-2758-9990-8. E-mail: mona.elbannan@guc.edu.eg Received: September 24, 2014 Accepted: October 29, 2014 Online Published: December 25, 2014 doi:10.5539/ijef.v7n1p216 URL: http://dx.doi.org/10.5539/ijef.v7n1p216 Abstract Although the Capital Asset Pricing Model (CAPM) has been one of the most useful and frequently used theories in determining the required rate of return of a security, the application of this model has been controversial since early 1960s. The CAPM was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. In theory, the capital asset pricing model is employed to set the investor required rate of return on a risky security given the non-diversifiable firm-specific risk, as the systematic risk will be eliminated in a well-diversified portfolio. This research aims to shed the light on this model by discussing the assumptions, the evolution of the Sharpe and Lintner model, and reviewing the literature on the relaxation of model assumptions and the critiques of the CAPM. Finally, the Arbitrage Pricing Model as an extension for the CAPM will be discussed. Keywords: Capital Asset Pricing model (CAPM), Beta, Intertemporal Capital Asset Pricing model (ICAPM), Consumption Capital Asset Pricing model (CCAPM), Arbitrage Pricing theory (APT) 1. Introduction The Capital Asset Pricing Model (CAPM) was introduced by William Sharpe (1964) and John Lintner (1965), resulting in a Nobel Prize for Sharpe in 1990. It is built on the earlier work of Harry Markowitz (1959) who developed the “mean-variance model” or model of portfolio choice. The model is used to determine a theoretically appropriate required rate of return of an asset, and thus the price could be also expected if firms can estimate the expected cash flows. Markowitz (1959) model suggests that investors choose a portfolio that will minimize the variance of portfolio return, given a specific level of expected return, or maximize expected return, given a specific level of variance. Thus, the Markowitz model is called a "mean-variance model” and assumes investors are efficient, risk averse and utility maximizing investors who select points that are located on the efficient frontier (called the minimum variance frontier) and hence, the portfolio selected depends on investor's risk-return utility function. Therefore, investors choose portfolios for only a single period of investment and focus on the mean and variance of their investment return, i.e. choose a portfolio at time t-1, which produces a stochastic (randomly determined) return at t. Sharpe (1964) and Lintner (1965) develop Markowitz model which depends on the tradeoff between risk and return, and introduce their models with additional two key assumptions. The first assumption is borrowing and lending at a risk free rate, that is, investors can borrow or lend any amount of money at the risk-free rate of return which is the same for all investors and does not depend on the amount borrowed or lent. The second assumption is that all investors have homogenous expectations which results in estimating identical probability distributions for future return, that is, total agreement on the distribution of asset returns from t-1 to t. Although the CAPM is widely used as it measures the expected rate of return of a security and relates it to expected risk, however, the empirical evidence shows that it is “poor enough to invalidate the way it is used in applications” (Fama & French, 2004). The study begins by discussing the development of the CAPM, the assumptions that it is build on, and the theoretical failings that resulted from simplifying many of these assumptions. Then the paper will review the articles that deal with the shortcomings of the CAPM which raises the need for alternative models such as the Arbitrage Pricing Model (APT).