Capital Market Theory - CAPM and the Efficient Frontier › Summary
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This chapter introduced the Capital Asset Pricing Model, which extends modern portfolio theory to derive equilibrium asset prices. The key insights and concepts include:
The introduction of a risk-free asset turns the efficient frontier from a curve into a straight line, the Capital Market Line (CML). All mean-variance investors combine the risk-free asset with the same tangency portfolio, which in equilibrium must be the market portfolio.
Systematic risk is the only risk that commands a premium in the market. Unsystematic (idiosyncratic) risk can be diversified away at no cost, so you should not expect compensation for bearing it. This insight is foundational for understanding how assets should be priced.
Beta measures an asset's systematic risk, its sensitivity to market movements. It captures how much an asset's return is expected to change for a 1% change in the market return. Beta is estimated through regression analysis and exhibits instability over time.
The Security Market Line (SML) describes the equilibrium relationship between expected return and beta for all assets: . This is the CAPM equation, the model's central prediction.
Alpha measures performance beyond what CAPM predicts. Positive alpha indicates outperformance after adjusting for systematic risk. Generating persistent positive alpha is the goal of active investment management, though distinguishing skill from luck remains challenging.
CAPM faces large empirical challenges, including the size effect, value effect, momentum, and the low-volatility anomaly. These failures motivated the development of multi-factor models. Nevertheless, CAPM provides a baseline framework for understanding risk-return relationships and remains the benchmark for evaluating investment performance.
In the next chapter, we'll explore Arbitrage Pricing Theory and multi-factor models, which address some of CAPM's limitations by allowing multiple sources of systematic risk.