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market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).
think of the formula as predicting a security's behavior as a function of beta: CAPM says that if you know
a security's beta then you know the value of r that investors expect it to have.
Naturally, somebody has to verify that this simple relationship actually holds true in the market. Part of the
question is how few classes you can get away with: whether you can use a very coarse division into just
"stocks" and "bonds", or whether you need to divide much further (into "domestic mid-cap value stocks",
and so on). There are also ongoing attempts at "building better betas" that incorporate company debt and
other traditional valuation measures, instead of relying solely on past volatility, to measure risk. All of this
is a full-time job for academic modern portfolio theorists (and deriding the whole effort is a popular hobby
for some traditional stock analysts: how could a magnificent company equal a mediocre one times beta?
To them, CAPM seems like a very blunt instrument.)
CAPM has a lot of important consequences. For one thing it turns finding the efficient frontier into a
doable task, because you only have to calculate the covariances of every pair of c l a s s e s , instead of every
pair of everything.
Another consequence is that CAPM implies that investing in individual stocks is pointless, because you
can duplicate the reward and risk characteristics of any security just by using the right mix of cash with
the appropriate asset class. This is why followers of MPT avoid stocks, and instead build portfolios out of
low cost index funds.
(One point about that last paragraph. If you are trying to duplicate an expected return that's greater than
that of the asset class, you have to hold "negative" cash, meaning you have to buy the index on margin.
This is consistent with the big message of MPT - that trying to beat the index is inherently risky).
CAPM - The Capital Asset Pricing Model
"Cap-M" looks at risk and rates of return and compares them to the overall stock market. If you use
CA P M y ou ha v e t o a s s u me t ha t m os t i n v e s t o rs w a n t t o a v o id r is k, ( ri s k a v e rs e ) , a n d t ho s e w h o d o t a ke
risks, expect to be rewarded. It also assumes that investors are "price takers" who can't influence the
price of assets or markets. With CAPM you assume that there are no transactional costs or taxation and
assets and securities are divisible into small little packets. Had enough with the assumptions yet? One
more. CAPM assumes that investors are not limited in their borrowing and lending under the risk freerate
of interest. By now you likely have a healthy feeling of skepticism. We'll deal with that below, but
B eta - Now, you gotta know aboutB eta.B eta is the overall risk in investing in a large market, like the
New York Stock Exchange.B eta, by definition equals 1.0000. 1 exactly. Each company also has a beta.
You can find a company's beta at the Yahoo!! Stock quote page. A company's beta is that company's risk
compared to the risk of the overall market. If the company has a beta of 3.0, then it is said to be 3 times
K s = K r f + B ( K m - K rf )
K rf = The Risk Free Rate (the rate of return on a "risk free investment", like U.S. Government
T re a s u r y Bo n d s - R e a d ou r D i s c l a im e r )
B = B e t a (s e e a b ov e )
K m = The expected return on the overall stock market. (You have to guess what rate of return