Market Model, CAPM, and Beta Forecasting

This chapter uses the concepts of basic portfolio analysis and dominance principle to derive the CAPM. A graphical approach is first utilized to derive the CAPM, after which a mathematical approach to the derivation is developed that illustrates how the market model can be used to decompose total risk into two components. This is followed by a discussion of the importance of beta in security analysis and further exploration of the determination and forecasting of beta. The discussion closes with the applications and implications of the CAPM, and the appendix offers empirical evidence of the risk–return relationship.In this chapter, we define both market beta and accounting beta, and how they are determined by different accounting and economic information. Then, we forecast both market beta and accounting beta. Finally, we propose a composite method to forecast beta.