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A model that describes the relationship between risk and expected return and that is used in the pricing of
risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of
money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and
compensates the investors for placing money in any investment over a period of time. The other half of
the formula represents risk and calculates the amount of compensation the investor needs for taking
on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the
asset to the market over a period of time and to the market premium (Rm-rf).

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The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security
plus a risk premium. If this expected return does not meet or beat the required return, then the investment
should not be undertaken. The security market line plots the results of the CAPM for all different risks
(betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in
this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected
market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

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£ill Sharpe made his first big breakthrough by taking the picture on the previous page and showing how
the market must price individual securities in relation to their asset class (a.k.a. the index, or the "optimal
mix" in the picture). The derivation isn't exactly a walk in the park (yikes!), but the result is a simple linear
relationship known as the Capital Asset Pricing Model:

r = Rf + beta x ( Km - Rf )
where
r is the expected return rate on a security;
Rf is the rate of a "risk-free" investment, i.e. cash;
Km is the return rate of the appropriate asset class.

£eta measures the volatility of the security, relative to the asset class. The equation is saying that
investors require higher levels of expected returns to compensate them for higher expected risk. You can
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 Ô
, 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
CAPM you have to assume that most investors want to avoid risk, (risk averse), and those who do take
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 free
rate of interest. By now you likely have a healthy feeling of skepticism. We'll deal with that below, but
first, let's work the CAPM formula.

£
- Now, you gotta know about £eta. £eta is the overall risk in investing in a large market, like the
New York Stock Exchange. £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
more risky than the overall market.

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× -s = The Required Rate of Return, (or just the rate of return).

× -rf = The Risk Free Rate (the rate of return on a "risk free investment", like U.S. Government
Treasury Bonds - Read our Disclaimer)
× B = Beta (see above)
× -m = The expected return on the overall stock market. (You have to guess what rate of return
you think the overall stock market will produce.)