Overview

Why does Apple stock cost $150 and Ford cost $12? Is it just supply and demand, or is there a fundamental value? Asset pricing models try to find the “correct” price.

Core Idea

Risk-Return Tradeoff: Higher risk must be compensated with higher expected return. No one buys a risky stock unless they think it will pay off big.

Formal Definition (if applicable)

CAPM (Capital Asset Pricing Model): $$ E(R_i) = R_f + \beta_i (E(R_m) - R_f) $$

  • Expected Return = Risk-Free Rate + Beta $\times$ Market Risk Premium.
  • Beta ($\beta$): A measure of how much the stock moves with the market. High beta = High risk.

Intuition

  • Risk-Free Rate: What you get for lending to the US government (safe).
  • Market Risk Premium: The extra return you get for investing in the stock market (risky).
  • Beta: If the market goes up 10%, does your stock go up 10% ($\beta=1$), 20% ($\beta=2$), or 5% ($\beta=0.5$)?

Examples

  • Arbitrage: Buying low in one market and selling high in another. (Risk-free profit).
  • Efficient Market Hypothesis (EMH): Prices already reflect all available information, so you can’t beat the market.

Common Misconceptions

  • “A good company is a good stock.” (Not if the price is too high.)
  • “Past performance predicts future results.” (It usually doesn’t.)
  • Alpha: The return you get above what CAPM predicts (skill).
  • Sharpe Ratio: Return per unit of risk.
  • Black-Scholes Model: Pricing options.

Applications

  • Portfolio Management: Selecting stocks.
  • Corporate Finance: Calculating the cost of capital.

Criticism / Limitations

CAPM assumes markets are rational and efficient. Behavioral finance says they aren’t. Fama-French models add more factors (size, value) to fix CAPM’s flaws.

Further Reading

  • Cochrane, Asset Pricing
  • Fama & French, Common Risk Factors in the Returns on Stocks and Bonds