ABSTRACT
The capital asset pricing model (CAPM), discussed in the previous chapter, was originally developed as an equilibrium pricing model and not as a risk model per se. As a pricing model, its function is to provide return expectations of individual stocks given their betas vs. a market portfolio and expected excess return of the market, that is,
E r r E r ri f i M f−( ) = ( ) − β . (3.1) In essence, CAPM states that the market should set prices of stocks
in a way such that their expected returns are proportional to their systematic risks measured by beta. Specic risks, on the other hand, can be diversied away by holding portfolios of stocks and therefore shall not be rewarded with excess returns.
