CAPM (Security Market Line)
Risk priced by beta: the security market line and the cost of equity.
The CAPM (Security Market Line) model, in writing
Definition
The capital asset pricing model: an asset's expected return is the risk-free rate plus a premium proportional to beta, its sensitivity to market-wide risk. Only undiversifiable risk is paid for.
E(R) = Rf + β·(E(Rm) − Rf)
The intuition
Risk you can wash out by holding many assets earns nothing, because everyone can diversify it away for free. What commands a premium is co-movement with the whole market, the risk that shows up exactly when everything else is falling too. High-beta assets are expensive insurance in reverse: they pay off in good times, so they must offer higher average returns.
Exam tip
Beta measures RELATIVE market risk: β=1 moves with the market, β>1 amplifies it. The security market line plots return against beta, not against total volatility.
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