ABSTRACT
A central idea of the standard CAPM is that there is only one risk that affects the long-term average return on an investment.That risk is market risk, which is the tendency of a stock to move in response to movements in the market as a whole. Market risk is measured by beta. Beta is often
approximated as the expected percentage change in a share price divided by the percentage change in a stock index. High beta stocks embody greater market risk; their price volatilities tend to be high relative to that of the market as a whole. (The multi-factor version of the CAPM proposed by Fama and French (1993) moves the model away from its reliance on a single risk factor.)
The capital asset pricing model is reflected in the security market line (SML).The equation for the security market line is:
E(Ri) Rf (E[Rm] Rf) (1)
where E(Ri) is the expected (or required) rate of return on security i, Rf is the risk-free rate of return (e.g. the return on Treasury bills), is the beta of the share, and E(Rm) is the expected return on the market portfolio (where the market portfolio is often approximated by a stock index portfolio).The term (E[Rm] Rf) is referred to as the risk premium.
