Capm

Section: Capital Asset Pricing Model (CAPM) Estimated study time: 45 minutes Content: The Capital Asset Pricing Model (CAPM), developed independently by Sharpe, Lintner, and Mossin in the 1960s, is the cornerstone of modern asset pricing theory. Building on Markowitz's portfolio theory, the CAPM derives the equilibrium relationship between systematic risk and expected return. The central equation is: E(Ri) = Rf + βi × [E(Rm) – Rf], where E(Ri) is the expected return on asset i, Rf is the risk-free rate, βi is the asset's beta (systematic risk relative to the market), and [E(Rm) – Rf] is the equity risk premium (ERP) — the expected excess return on the market portfolio above the risk-free rate. The CAPM makes a powerful statement: in equilibrium, an asset's expected return is linearly related to its beta — its contribution to the market portfolio's variance. Beta measures the systematic risk of an asset: βi = Cov(Ri, Rm) / Var(Rm) = ρi,m × (σi / σm). A beta of 1.0 means the asset moves with the market; β > 1.0 (aggressive stocks) means the asset is more volatile than the market; β < 1.0 (defensive stocks) means less volatile. Beta of the market portfolio itself = 1.0 by definition. The risk-free asset has β = 0. Portfolio beta is the weighted average of individual security betas. The CAPM separates total risk (standard deviation) into systematic risk (β × σm) and unsystematic risk — and critically, only systematic risk (beta) is priced (compensated with higher expected return) because unsystematic risk can be diversified away at no cost. The Security Market Line (SML) is the graphical representation of the CAPM, plotting expected return on the y-axis and…