How is CAPM an equilibrium model?

[oktavian]

E® = rf + β(E(Rm) - rf)

In what way does the CAPM formula rely on supply and demand being balanced?

How does that formula fall apart if supply and demand are not balanced?

Happy new year from China!

[MrSmart]

CAPM is a cross-sectional model, it assumes no residual error, and all prices and returns are affected only by relative systematic risk, and not supply/demand disequilibrium. Meaning that, all participants are price takers, and the market is efficent.

[S666]

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[oktavian]

Thanks guys, so is there some variable that is assumed to be in equilibrium (equal to 0?) for the CAPM to hold?

“cross-sectional” and “no residual error” are words I don’t know. Should I know that from Level 2 or should I google it?

This is the bit from the CFA book that got me on the track of demand/supply equilibrium:

Financial equilibrium models describe relationships between expected return and risk in which supply and demand are in balance. In that sense, equilibrium prices or equilibrium returns are fair if the equilibrium model is correct.

Equilibrium approaches to setting capital market expectations include the Black–Litterman approach and the international CAPM–based approach presented in Singer and Terhaar (1997).

[MrSmart]

Never mind all the technicalities (sp?).

Just understand that it means that the investor is a price taker, and the market is fairly valued at all times.

If both of these hold, then there will be no supply/demand imbalance.

Consider a CAPM predicting for a stock to return 10% annually, but the stock is also highly illiquid (due to short supply, not short demand), then your returns can be potentially much higher than your expected return given its inherit risk, due to market imbalance rather than risk pricing.

[GothamSenator]

@oktavian

or should I google it?

always Google it…

and Happy New Year!!

[oktavian]

Thanks!