Introduction to CAPM

According to the famous CAPM, the expected returns of a stock are linearly correlated with expected market returns. Here, we use the international business machine with a ticker of IBM as an example and this linear one-factor asset pricing model could be applied to any other stocks or portfolios. The formula is given here:

Here, E() is the expectation, E(R_IBM) is the expected return for IBM, R_f is the risk-free rate, and E(R_mkt) is the expected market return. For instance, the S&P500 index could be served as a market index. The slope of the preceding equation or is a measure of IBM's market risk. To make our notation simpler, the expectation could be dropped:

Actually, we could consider the relationship between the excess stock returns and the excess market returns. The following formula is essentially the same as the preceding formula, but it has a better and clearer interpretation:

Recall that in Chapter 3, Time Value of Money, we learnt that the difference between...