• The risk premium is the premium demanded by investors for investing in the market
portfolio, which includes all risky assets in the market, instead of investing in a
riskless asset. Thus, it does not relate to any individual risky asset but to risky assets
as a class.
• The beta, which we defined to be the covariance of the asset divided by the market
portfolio, is the only firm-specific input in this equation. In other words, the only
reason two investments have different expected returns in the capital asset pricing
model is because they have different betas.
In summary, in the capital asset pricing model all of the market risk is captured in one
beta, measured relative to a market portfolio, which at least in theory should include all
traded assets in the market place held in proportion to their market value.
☞: 3.6. What do negative betas mean?
In the capital asset pricing model, there are assets that can have betas that are less than
zero. When this occurs, which of the following statements describes your investment?
a. This investment will have an expected return less than the riskless rate
b. This investment insures your “diversified portfolio” against some type of market risk
c. Holding this asset makes sense only if you are well diversified
d. All of the above
In Practice: Index Funds and Market Portfolios
Many critics of the capital asset pricing model seize on its conclusion that all
investors in the market will hold the market portfolio, which includes all assets in
proportion to their market value, as evidence that it is an unrealistic model. But is it? It is
true that not all assets in the world are traded and that there are transactions costs. It is
also true that investors sometimes trade on inside information and often hold
undiversified portfolios. However, we can create portfolios that closely resemble the
market portfolio using index funds. An index fund replicates an index by buying all of the
stocks in the index, in the same proportions that they form of the index. The earliest and
still the largest one is the Vanguard 500 Index fund, which replicates the S&P 500 index.
Today, we have access to index funds that replicate smaller companies in the United
States, European stocks, Latin American markets and Asian equities as well as bond and