Risk priced by beta: the security market line and the cost of equity.
Warming up the engine…
The capital asset pricing model: an asset's expected return is the risk-free rate plus a premium proportional to beta, its sensitivity to market-wide risk. Only undiversifiable risk is paid for.
E(R) = Rf + β·(E(Rm) − Rf)
Risk you can wash out by holding many assets earns nothing, because everyone can diversify it away for free. What commands a premium is co-movement with the whole market, the risk that shows up exactly when everything else is falling too. High-beta assets are expensive insurance in reverse: they pay off in good times, so they must offer higher average returns.
Beta measures RELATIVE market risk: β=1 moves with the market, β>1 amplifies it. The security market line plots return against beta, not against total volatility.
Now prove you have it
Move the curve to where you think it lands, and get told exactly which part you got right.
Real-world scenarios on this model
Equilibrium at β 1.0, E[r] 8.5.
Equilibrium: β* = 1.0, E[r]* = 8.5
Current equations
Why do risky assets pay more? Only the risk you CAN'T diversify away counts, betabetaAn asset's sensitivity to market-wide swings, the only risk that earns a premium in the CAPM. measures it. The Security Market Line prices every asset: start at the risk-free rate, add beta times the market premium.