Now we're about to start to look at one of

the most famous formulas in corporate finance

that has a very generic name Capital Asset Pricing Model.

The fact that it's sort of generic,

a test to the idea that it is widespread if you will.

Now I will start with the following chart,

and this is Beta,

and this is the expected return.

And again, there are two special points now.

One is risk-free with the Beta of zero and there is another special point.

If I put Beta1 here.

this is the market portfolio.

Now, I can easily draw a straight line here.

That is a special name that secures the market line,

and now this line is special in the following way.

Well, if we take a look at any portfolio or any security that's let's say is here,

then we can say that this is not a good investment because you can always find a better

one by going up here by the same token if we take B here.

Again you can say, well, this is not a good investment

because for the same level of risk,

we can find a better investment here.

And again, what is this investment?

This is sort of a combination of the market portfolio and borrowing or lending.

For example here, if for this portal A,

Beta is somewhere about 0.6 then,

or you can take a corresponding part of the risk-free portfolio,

and then you will come up here.

Here is Beta is greater,

here you are lending,

so you invest part of your money in the risk-free asset.

Here, you are borrowing because you have to borrow

some money and then invest that in the market portfolio and you come up here.

Now if all these investments that are below this lines are bad,

then on average as we all know these investments lay on this line and therefore,

all of the investments they cannot be

below this line and therefore they

cannot be above this line either because on average they're here.

Then the conclusion goes on all investments should be on this line.

And that leads us to the idea of Capital Asset Pricing Model.

So we can say that for any asset,

there is a linear relations

between the risk Premium and its Beta.

Well, let's proceed. And so,

if this is the case,

we can say that for any asset RI,

it's RF plus sum Lambda

times beta for this asset and this lambda is the same for all assets,

therefore, we can use a special case where I is the market.

And then writing that,

we can see that this Lambda is nothing but RM minus RF.

Because beta for the market is one,

then you can see what Lambda is.

And we, come up with

a famous Capital Asset Pricing Model formula that says, for any asset,

it's expected return is equal to RF plus Beta of this asset times RM minus RF.

Well, strictly speaking, strictly speaking,

these RM and RF are not constants.

But they are quasar constants because we can say that the volatility of

any asset is higher than the volatility of the overall market and the volatility of RF.

Although clearly, every day RF and RM changes,

Both RM changes and RM does so.

But we can say that the general idea that has led us to this formula is the fact that

the market portfolio is efficient.