The Capital Asset Pricing Model and Beyond
Capital Market Theory builds on Modern Portfolio Theory by introducing a risk-free asset. The key insight is that if all investors have the same expectations (homogeneous expectations), they will all identify the same optimal risky portfolio. This market-wide optimal risky portfolio is called the market portfolio.
The Capital Market Line (CML) is the "best" possible Capital Allocation Line, where the risky portfolio is the market portfolio. It represents the risk-return trade-off for all efficient portfolios (portfolios combining the risk-free asset and the market portfolio).
The slope of the CML, (E(Rm) - Rf) / σm, is known as the market price of risk.
The total risk of any individual security can be broken down into two components:
Also known as market risk or non-diversifiable risk. This is the risk that affects the entire market or economy (e.g., changes in interest rates, recessions). It cannot be eliminated through diversification.
Also known as specific risk, idiosyncratic risk, or diversifiable risk. This is the risk that affects only a single company or industry (e.g., a product recall, a factory fire). This type of risk can be virtually eliminated in a well-diversified portfolio.
In a diversified portfolio, investors are only compensated for bearing systematic risk. The market does not reward investors for taking on nonsystematic risk because it can be diversified away.
The CAPM is a model that describes the relationship between systematic risk and the expected return for any asset. It provides a way to price risk.
The Security Market Line (SML) is the graphical representation of the CAPM. It plots the expected return of any security or portfolio against its systematic risk, as measured by beta (β).
Where:
Security Valuation:
If a security's expected return plots above the SML, it is undervalued. If it plots below, it is overvalued.
Beta measures the sensitivity of an asset's returns to the returns of the overall market.
The asset moves in line with the market.
The asset is more volatile than the market.
The asset is less volatile than the market.
The asset's movement is unrelated to the market.
Several ratios are used to measure a portfolio's risk-adjusted performance.
Interpretation: Excess return per unit of total risk.
Best for evaluating a total portfolio. Uses total risk (σp).
Interpretation: Excess return per unit of systematic risk.
Best for evaluating individual assets within a diversified portfolio. Uses systematic risk (βp).
Interpretation: The excess return above or below the return predicted by the CAPM.
A positive alpha indicates outperformance.
Interpretation: The return of a portfolio that has been leveraged to match the market's risk.
Provides a risk-adjusted performance measure in percentage terms.
While the CAPM is foundational, it has limitations (e.g., its assumptions are unrealistic, the true market portfolio is unobservable). As a result, more complex models have been developed.
A more flexible model that allows for multiple sources of systematic risk (e.g., inflation, GDP growth), but it doesn't specify what those factors are.
Models like the Fama-French three-factor model expand on the CAPM by adding factors for size (SMB - small minus big) and value (HML - high minus low) to better explain stock returns.