Hello everyone, welcome back. Well, ladies and gentlemen, we're finally ready for the capital asset pricing model, the most well-known asset pricing model in finance. So in this lecture, you're going to learn about the main expected return and risk relationship predicted by the capital asset pricing model, okay. So remember last time, we reviewed the concepts of systematic risk and non-systematic risk, right? And we reiterated the fact that we can diversify a way all of the non-systematic risk but we can't eliminate the systematic risk of an asset, right. So what's critical is that since we can eliminate, right, get rid of, all of the systematic risk, right? Investors need not be rewarded for this kind of risk, right, because it can be diversified away. The only part of total risk that investors will get paid for, right, therefore is the systematic risk. Right, the risk that diversification can help, right. What we measure with the beta, right. So now [COUGH] we're ready to write down the CAPM relationship, right? The expected return-beta relationship, right? So ladies and gentlemen, here is the CAPM, basically what does the CAPM say? The CAPM says, the expected return on any assets is given by the risk free rate, right. Plus a risk premium, right. And what is that risk premium? Well that risk premium is given by the asset's beta times, right, the market, Risk premium. All right, so this is the asset beta. And this is what we call the market risk premium, right? It's the excess return that the market portfolio provides above and beyond the risk free rate. Alternatively you can write this as, right? The excess return, right, the risk premium on this asset is equal to risk-free rate, sorry, I moved that already. Beta times, All right. So what does this say? This says that the extra return, right, that a risky asset should offer, right? The risk premium, Additional offer, in equilibrium, right, is proportional to its beta. In other words, the expected return on the asset is entirely determined by how much systematic risk it has, right? The only thing that matters is the asset's beta. Another way to state the CAPM relationship is the security market line, right, which basically depicts the CAPM relationship as a graph, right. It's the relationship between the expected return and the beta, right. What does it look like? Well, the risk free asset, right, has a beta of 0, right. The market portfolio has a beta of 1, right, because it has all of the market risk. So that's the risk free rate. That's the expected return on the market, right? So the security market line, Is a line, right, that goes through the risk-free rate and the market portfolio. And in equilibrium, right, what CAPM says is that, in equilibrium, all assets should lie on this equilibrium market line. Okay, so let's recap. The capital as a pricing model, right, states the relationship between risk and reward, right, when investors are risk averse and they have mean various preferences, right? CAPM says, that in equilibrium, everyone holds a combination of the market portfolio and the risk free asset, right? And the extra return that needs to be offered by each individual risk security, right, depends on the asset's beta. How much systematic risk the asset adds to the investors portfolio. Okay, so here is another way of thinking about the CAPM. Now, investors find high beta assets unattractive. Why? Well, think about it. These are the assets, right, high beta assets. These are the assets that could move strongly with the rest of the market, right? And, therefore, they offer very little diversification benefits. In fact, because they have high betas, right, they are the ones that do very, very poorly when the rest of the market does poorly as well, right. This is what we call the bad times, right, for an investor. So if an investor is to hold these assets,right, they would require higher expected returns to be compensated for the fact that these assets do badly in bad times, when the market portfolio return is low, right. Precisely when investors hurt the most, right. Now in contrast, right, think about assets with low betas or even negative betas. Well these assets do not co-move strongly with the market and therefore, right, they offer great diversification benefits, right. Especially when investors need it most. So these assets are very attractive to investors. And investors do not need to be compensated very much for holding them. All right. So basically CAPM says that there is only one risk factor, right, one risk source, and that is the market portfolio. All right so, in a CAPM world, bad times for investors, all right, are defined as when the market as a whole is not doing well, right. And investors will require as premium for holding assets that do poorly, especially in bad times. All right, which are basically high beta assets. All right okay, so in this lecture, you learned the main risk and return relationship predicted by our most well-known model, the capital asset pricing model, right. You learned that the risk premium on an individual asset is determined by its beta, right, which measures the systematic risk. And another way to think about the CAPM is how it defines the bad times for investors, right? It defines bad times as periods with low market returns, right? And losses during bad times are more likely with high beta assets, and therefore high beta assets are riskier. And therefore require higher expected returns to be held in equilibrium.
