๐Ÿ”บ CAPM Prices Relative Volatility, Not Business Risk

The Capital Asset Pricing Model (CAPM) tries to price the risk of an asset, particularly for stocks, and simultaneously becomes the expected rate of return, required rate of return, hurdle rate, and the discount rate. In other words, an investor would not invest in the asset unless the expected return on the asset was at-or-above the hurdle rate as specified by CAPM.

CAPM prices the opportunity cost of the risk free rate and expected market return coupled with relative volatility. Breaking it down further, the ultimate risk being priced is the relative volatility because it is assumed that idiosyncratic risks can be diversified away leaving only systemic risks.

The underlying assumptions are that relative volatility is the only risk that matters, markets are informationally efficient, and in order to generate a higher return you have to take on more risk. Yet, business risk and relative volatility are not the same. Moreover, to achieve a greater return, you have to take on greater uncertainty, which implies more risk, but not necessarily so if the uncertainty/risk/reward profile is favorable. A better measure of risk is the relative implied expectations of an asset(s).

Please refer to the following analysis: ๐Ÿ”บ Risk, Uncertainty, and Managing Uncertainty https://internationalcapitalmarkets.org/2020/08/21/%f0%9f%94%ba-risk-uncertainty-and-managing-uncertainty/ via @Diamond1_CEO

Published by Diamond1

I have an extensive background throughout the financial spectrum with high-level experience on the sell-side, high-net worth private banking, portfolio management, international finance, public pensions, VC, PE, and economics. I enjoy working and collaborating with people that I admire and trust.

"Fit Models to Problems, Not Problems to Models"

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