Asset Pricing Theory

Capital Asset Pricing Model (CAPM)

• Any stock’s required rate of return is equal to the risk-free rate of return which compensates for delay plus a risk premium which compensates for only the risk remaining after diversification (systematic risk)

• Is the result of modern portfolio theory (MPT)

• Is consistent with the time value of money – compensating investors for both delay and uncertainty

(𝐸[𝑅𝑖])

Expected Return

The purpose of the CAPM is…

To estimate the expected return of an investment

_________ allows us to estimate what the appropriate expected return would be given how risky (how uncertain) the investment is

CAPM

(𝑅𝑓)

Risk Free Rate

Risk-Free Rate

The rate of return on an investment that has no risk

(𝐸[𝑅𝑀𝐾𝑇]−𝑅𝑓) or λ

The Market Risk Premium

The Market Risk Premium

The amount of additional return I would need to give you to take your money out of an investment with a guaranteed return and invest it in a risky portfolio (the market portfolio)

MKT

The Market Portfolio

The Market Portfolio

A portfolio consisting of all stocks in existence in proportion to their market capitalization

(𝐸[𝑅𝑀𝐾𝑇])

The Expected Market Return

The Expected Market Return

The average return that investors expect to receive from the market portfolio (which is the portfolio that contains every stock in proportion to their market capitalization)

What does a beta greater than 1 imply?

The returns of the individual investment are more volatile than the returns of the market portfolio

What does a beta less than 1 imply?

The returns of the individual investment are less volatile than the returns of the market portfolio

What does a beta of 1 imply?

The returns of the individual investment moves exactly with the market portfolio

_________ is the appropriate measure of uncertainty for a portfolio

Beta

Beta

A measure of how sensitive a stock’s return is to changes in the macroeconomic conditions which affect the stock market

Beta of a Portfolio

• The weighted average of the betas of the individual assets in the portfolio

• Measures the portfolio’s sensitivity to market risk (systematic risk)

• Higher beta → more sensitive to market movements

• Lower beta → less sensitive