Chapter 8: Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) begins by distinguishing between specific risk, which is unique to a company and can be eliminated through diversification, and market risk, which is systematic and unavoidable. The text establishes that in a competitive market, investors are only compensated for bearing market risk, which is quantified by beta. Beta measures the sensitivity of an individual security's returns relative to the market portfolio; a beta of one implies average market risk, while a beta greater than one indicates higher volatility. The chapter articulates the core CAPM formula, stating that the expected risk premium of a stock is equal to its beta multiplied by the market risk premium. This relationship is graphically represented by the Security Market Line (SML), which sets the standard for the required rate of return for any given level of systematic risk. The authors also explore the economic intuition behind the model, explaining that high-beta stocks require higher returns because they perform well during economic booms when the marginal utility of additional wealth is low, but crash during recessions when wealth is most needed. The discussion then moves to empirical evidence, examining whether the CAPM holds true in the real world. While historical data confirms that riskier assets generally yield higher returns, the actual relationship is often flatter than the theory predicts, with high-beta stocks often underperforming expectations. Consequently, the chapter introduces alternative pricing models to address these anomalies, specifically the Arbitrage Pricing Theory (APT), which posits that returns are driven by multiple macroeconomic factors rather than a single market index. Finally, the text details the Fama-French Three-Factor Model, which expands upon standard asset pricing by including size and book-to-market ratios as distinct risk factors to better estimate the cost of equity capital.