SHARE:

# 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.

## Credits and Collaboration

Click the following links to see the codeline-by-line contributions to this presentation, and all the collaborators who have contributed to 5-Minute Finance via GitHub.