The Capital Asset Pricing Model

The CAPM

The basic idea of the CAPM is this: A stock is more risky the more its performance is correlated with the other stocks you hold.

• The CAPM assumes all investors will hold the market portfolio.

• If all investors hold the market portfolio, then an asset’s risk is simply the amount the asset contributes to the risk of the overall market portfolio.

The Following App

In the following app, the returns on stock 1 are fixed. The expected returns are 10% on both stock 1 and 2.

You can change the returns on stock 2 so that is has a -1, 0, or 1 correlation with stock 1. Look at the result of your choice on the variation in portfolio returns.

• Decreasing the correlation lowers the portfolio risk to 0, while the expected return on the portfolio is still 10% (the correlation has no effect on the portfolio expected return).
• Risk is 0 because over time the return is constant.
• If the correlation is 1, then the portfolio is just as risky as holding one of the stocks.

What Does This Mean for Return?

If a stock lowers our portfolio risk, we won’t require too high of a return from that stock.

On the other hand, if a stock raises our portfolio risk, we’ll ask for more return to compensate us for taking on the additional risk.

Formal Statement

The amount by which a stock adds to portfolio risk (assuming you invest in the market) is measured by its Beta coefficient. So we can say:

• Higher Beta coefficient means a higher expected return on the stock.
• Lower Beta coefficient means a lower expected return on the stock.

The Following App

The following app will calculate a Beta coefficient for any stock you choose using the stock’s actual historical data.

• On what type of stock will you tend to require a higher return?

• You can find the beta of entire stock sectors by putting in sector-specific Exchange Traded Fund (ETF) tickers.

CAPM with 95% Confidence Interval