2.1 The capital pricing model The CAPM is one of the most influential theories in finance and is widely used in applications (e.g. for estimating the cost of capital for companies). Meanwhile, the CAPM is probably the most tested model. The beauty of the CAPM comes from its parsimony and elegance in establishing a linear relationship between risk and return. The CAPM indicates that if an investor wants to earn a higher expected rate of return, he or she must bear additional risk. It is derived based on the mean-variance approach, first proposed by Markowitz (1959). The mean-variance approach states that the mean is an indicator of the return of the asset and the variance represents the risk incurred by the asset. If two assets have the same return, the investor will choose to invest in the asset with the lowest degree of risk. If two assets have the same degree of risk, the investor will choose to purchase the asset with the higher return. Sharpe (1964) is the first to apply the mean-variance approach to construct a market equilibrium theory of asset prices under conditions of risk. First, Sharpe defines the investor's utility function with only two parameters: the expected value and the standard deviation. U=f(E_w,σ_w) where E_w is expected future wealth and σ_w indicates the expected standard deviation of the possible divergence of actual future wealth from expected future wealth E_w. Therefore, for risk-averse investors, dU⁄(dE_w )>0 and dU⁄(dσ_w )<0. In the presence of two risky assets, the investment opportunity curve is determined by the expected rate of return of the assets, the risk and the correlation between the different assets. The same analysis also applies to determining the utility of an investor who invests in the combination of re......middle of paper...librium in a Capital Asset Market, Econometrics, 34(4), pp. 768–783. Mossin, J., 1969, Security prices and investment criteria in competitive markets, American Economic Review, 59, pp. 749-756. Rendleman, R.J., 1999, Option Investing from a Risk-Return Perspective, The Journal of Portfolio Management, pp. 109-121. Ross, S.A., 1976, The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory, 13, pp. 341-360. Rozeff, M.S. and Kinney Jr, W.R., 1976, Capital market seasonality: the case of stock returns. Journal of Financial Economics, 3, pp. 379–402.Rubinstein, M., 1976, The Valuation of Uncertain Income Streams and the Pricing of Options, Bell Journal of Economics and Management Science, 7, pp. 407-425.Sharpe, W.F., 1964, Capital goods prices: a theory of market equilibrium under conditions of risk, Journal of Finance, 19(3), pp. 425-442.