Chapter 4. Pricing the Risk: Capital Asset Pricing Model (CAPM) and Beta

Welcome back. Previously, we learned how to eliminate unsystematic risk through portfolios. Today, we tackle one of the greatest formulas in modern finance: the Capital Asset Pricing Model (CAPM).

The CAPM starts with a bold question: “Exactly how much compensation does the market provide for risk?” This model serves as a compass not only for individual stocks but also for evaluating corporate capital costs and project feasibility. Let’s dive into the world of logic that earned William Sharpe a Nobel Prize.

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1. Prerequisites: The Ideal Market

The CAPM assumes a ‘clean’ market: rational investors, light-speed information, and zero taxes or transaction costs. While reality is different, this framework allows us to see the “fundamental skeleton of risk and return.”

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2. Beta ($\beta$): Your Sensitivity to the Market

The star of the CAPM is Beta ($\beta$). It ignores small, diversifiable risks and measures only how much you move when the market as a whole shakes.

The Philosophy of Beta: A beta of 1.5 means if the index rises by 1%, your stock rises by 1.5%. Conversely, if the index drops 1%, yours drops 1.5%. It means: “If you want higher returns, endure a higher beta (market risk).“

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3. The CAPM Formula: The Price Tag of Risk

Here is the golden formula of finance:

$E(R_i) = R_f + \beta_i \times [E(R_m) - R_f]$

• $R_f$ (Risk-Free Rate): Interest rate on government bonds with zero risk (Compensation for waiting).
• $[E(R_m) - R_f]$ (Market Risk Premium): Compensation for jumping into a risky market.
• $\beta_i$: The weight of how much you reflect that market risk.

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4. Security Market Line (SML): Where is Your Stock?

The graph of this formula is the Security Market Line (SML).

• Points ABOVE the SML: Return is too high for the risk. “Undervalued”—Time to Buy.
• Points BELOW the SML: Risk is high but return is poor. “Overvalued”—Time to Sell.

Convergence of Efficient Markets: If markets are efficient, all assets eventually move back to the SML as abnormal profits disappear quickly.

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5. Conclusion: He Who Manages Beta Wins

Today, we learned how to put a price on risk. The CAPM teaches us that simply taking risks doesn’t guarantee returns; what matters is understanding the “Risk the market compensates for (Systematic Risk).”

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📖 참고문헌

• [Investments] - Bodie, Kane, Marcus: The legendary textbook covering everything in modern portfolio theory.
• [The Psychology of Finance] - Lars Tvede: A critical look at why the ‘rational human’ assumed by CAPM often fails in reality.
• [Empire of Wealth] - John Steele Gordon: The fascinating history of how mathematical models came to dominate Wall Street.

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Next time, we will learn about the tool for deciding a company’s destiny—whether to build a new factory or launch a new product: Capital Budgeting: The Battle of NPV vs. IRR.