Capital asset pricing model

Welcome to the fifth episode of our Financial Economics course. Building on Portfolio Theory, this episode introduces the **Capital Asset Pricing Model (CAPM)**, a foundational model in finance used to determine the appropriate expected return for an investment. You will learn the crucial difference between diversifiable and systematic risk, and why the market only rewards investors for bearing the latter. We will break down the CAPM formula, explaining each component including the risk-free rate, the market risk premium, and the all-important 'beta'—a measure of a stock's volatility relative to the market. Discover how CAPM provides a powerful framework for understanding the relationship between risk and reward.

Check your understanding

These are the same multiple-choice questions you will see in the Quiz section after you listen to the episode. Use them here to preview or review the answers.

What is the primary purpose of the Capital Asset Pricing Model (CAPM)?

  1. To guarantee a positive return on all investments.
  2. To determine the theoretically appropriate expected return of an asset based on its risk.
  3. To pick stocks that will outperform the market.
  4. To provide a framework for linking systematic risk to expected return.
  5. To eliminate all investment risk.

According to CAPM, why are investors not compensated for bearing unsystematic (or diversifiable) risk?

  1. Because unsystematic risk does not affect a company's profits.
  2. Because this type of risk can be virtually eliminated for free by holding a well-diversified portfolio.
  3. Because it is impossible to measure unsystematic risk.
  4. Because the market only rewards investors for taking on unavoidable, market-wide risk.
  5. Because only systematic risk is considered 'real' risk in the model.

In the CAPM formula, what does a stock's 'Beta' represent?

  1. The total return of the stock over the past year.
  2. A measure of the stock's unsystematic, company-specific risk.
  3. A measure of the stock's volatility, or systematic risk, relative to the overall market.
  4. The risk-free rate of return.
  5. The likelihood that the company will go bankrupt.

A stock has a Beta of 1.2. What does this imply?

  1. The stock is less volatile than the overall market.
  2. The stock is expected to move in the same direction as the market, but with 20% greater volatility.
  3. The stock's expected return will be lower than the market return.
  4. The stock carries more systematic risk than the average stock in the market.
  5. The stock is a risk-free asset.

What does the Security Market Line (SML) illustrate?

  1. The relationship between a company's debt and its stock price.
  2. The historical performance of the stock market.
  3. That a stock plotting below the SML is considered undervalued.
  4. The required rate of return for an asset for any given level of systematic risk (Beta).
  5. That a stock plotting above the SML may be a good investment.

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