071 Capital Assets Pricing Model - CAPM
- Recommended read: Grinold & Kahn Chapter 2
Assumptions:
- Return on stock is a mix of:
- Systematic return:
- The whole market moves in a direction, and carries the stocks with it
- Return of the market: rm
- Susceptibility of a stock to be 'carried away' by the market (market correlation): β
- Residual return:
- The stock moves somewhat randomly from the market
- Difference from the market in a given day: α
- Expected value of the residual is 0: E(α) = 0
ri = βi*rm + αi
- Market return = risk free rate of return + excess return
- Risk free rate of return is usually bank interest rate
- A market portfolio is a market-cap weighted index
- US S&P500
- UK FTA
- Japan TOPIX