CAPM: Equilibrium Portfolios and Expected Returns

Summary

The document introduces the Capital Asset Pricing Model as an equilibrium framework linking systematic risk to expected return. It explains the model’s roots in portfolio theory and outlines assumptions including competitive markets, a single investment period, tradable assets, no taxes or transaction costs, shared expectations, and borrowing or short selling at the risk-free rate.

It describes how investors combine a risk-free asset with the market portfolio, distinguishing the Capital Market Line from a general capital allocation line. For individual securities, beta measures contribution to portfolio risk and determines the model’s expected return relative to the risk-free rate and market risk premium. A worked example applies the formula to a hypothetical stock using stated market, Treasury, and beta inputs. The article is an introductory explanation rather than an empirical test; its conclusions rely on idealized assumptions, and the document acknowledges that the model has limitations.

Key ideas

• CAPM relates expected asset returns to systematic risk measured by beta.
• Under the model’s shared-expectations equilibrium, investors combine a risk-free asset with the market portfolio.
• The Capital Market Line describes combinations of the risk-free asset and market portfolio, while a capital allocation line can use other risky portfolios.
• The model depends on simplifying assumptions such as no transaction costs, no taxes, and uniform expectations.
• The example estimates a stock’s expected return from the risk-free rate, beta, and market risk premium.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.