Risk and Capital Asset Pricing

Why are your stocks worth what they're worth? Why are the bonds you have trading at the amount that they are trading at? These questions can be answered by taking a look at capital asset pricing. Capital asset pricing is a way of placing a value on assets by looking at their expected risk and anticipated return. That is about as simple as it gets, how much risk is there and how much will it pay. These two questions should determine the price of a security in the open market, but how? There are two methods used to answer this; The Capital Asset Pricing Model (CAPM) and the arbitrage price theory (APT).

Both methods make the assumption that the variability in an assets returns (the risk) is caused by two factors. First are market wide forces. These forces affect all assets, or at least all assets in a category. An example of this could be the state of the economy, which as it fluctuates, causes variability in the returns of the assets in that market. Next is risk that comes from causes which are specific to the firm or company who is the backing for a particular security. This can result from anything from the firm losing a big client to its workers going on strike.

The first type of risk, the market wide type, is known as non-diversifiable (sometimes called systematic) risk. The second type, the firm specific variety, is known as unsystematic (sometimes called diversifiable). Unsystematic risk is the easy one. It's effects can be canceled out by building a well diversified portfolio. Systematic risk, however, is a different story. This is the risk that your chosen securities will face no matter what, and thus this is the main risk that you need to be compensated for bearing.

So this is how the market arrives at a price for a security. The market, as a whole, decides how well the risk involved with the company can simply be diversified out (unsystematic) and also how volatile the market in which the asset operates is (systematic). Between these to risk factors a general consensus is reached about how much return the buyers in the market expect to see based on the amount of risk that they will have to take on by purchasing this asset.