The grim discovery that’s spooked the City

The capital asset pricing model - a popular system for valuing shares - relied on risk-free government bonds for a yardstick. But government bonds are no longer risk free, and the model is bust, says Tim Bennett. So what happens now?

As a private investor, you're unlikely to buy or sell enough shares to move a company's share price significantly, at least outside the smallest stocks. In that sense, you are a price taker', in City parlance. The price makers' are the big institutions that trade vast quantities of shares.

But how do they decide what price a stock should be? For years, most City institutions, from fund managers to banks, have put their faith in one model above all others. It's called the Capital Asset Pricing Model (CAPM). Never intended as a model for valuing individual shares, that's nonetheless how it is widely used. What's terrifying the City now is that, due to the credit crunch, the model is bust its two key assumptions have collapsed. Worse still, no one knows what to replace it with. In the short term at least, that could be bad for share prices.

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Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.