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The Capital Market Valley

This is my view (no pun intended?) of the Capital Asset Pricing Model.

The conventional graphical representation of the CAPM is 2-dimensional. Risk, measured in terms of beta causes return to increase along the line that connects the risk-free rate (f) at a beta of 0 and the market return (m) at a beta of 1. Sometimes the higher borrowing rate is used to show that the resulting "capital market line" may be kinked as defined by the higher rate for borrowing, creating a line that crosses at the borrowing rate (b) and which applies for betas greater than 1. That 2D graph is the floor of this 3D interpretation.

The idea that the graph tries to convey is that price corrections are not written in stone. The arbitrage that is somewhat hampered by the higher borrowing rate is further hindered by margin rules which further impede arbitrage above betas of 2. Also, the higher borrowing rate only limits arbitrage to reduce prices, the regular capital market line is still valid. Moreover, all along the two capital market lines, small price corrections are not undertaken because of transaction costs and because of risk. Accordingly, the CAPM should be viewed as a valley akin to the above. Large deviations are corrected, but small ones are not; the borrowing rate widens the floor, and margin rules further widen it. Stock prices are like beanie babies thrown onto the valley; they only exist momentarily far from the line, but they may stick at a small distance from the lines.

As I was playing with the graphics, I heard the voice of Obi-Wan Kenobi. I knew the Power would be with me, so I tried to fly through a Capital Market canyon in my X-Wing:

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See all the 3D graphs together