Bodie17 shows that the price of such a put necessarily increases as the investment horizon is longer. Therefore, time diversification does not eliminate risk: in fact, the cost of insuring returns increases with the investment horizon.

17 Zvi Bodie, "On the Risk of Stocks in the Long Run," Financial Analysts Journal 51 (May/June 1995), pp. 18-22.

III. Equilibrium In Capital

Markets

9. The Capital Asset

Pricing Model

The McGraw−Hill

Companies, 2001

C H A P T E R N I N E

THE CAPITAL ASSET PRICING MODEL

The capital asset pricing model, almost always referred to as the CAPM, is a cen- terpiece of modern financial economics. The model gives us a precise prediction of the relationship that we should observe between the risk of an asset and its ex- pected return. This relationship serves two vital functions. First, it provides a benchmark rate of return for evaluating possible investments. For example, if we are analyzing securities, we might be interested in whether the expected return we forecast for a stock is more or less than its "fair" return given its risk. Second, the model helps us to make an edu- cated guess as to the expected return on assets that have not yet been traded in the marketplace. For example, how do we price an initial public offering of stock? How will a major new invest- ment project affect the return investors require on a companys stock? Al- though the CAPM does not fully with- stand empirical tests, it is widely used because of the insight it offers and be- cause its accuracy suffices for impor- tant applications. In this chapter we first inquire about the process by which the attempts of individual investors to efficiently diversify their portfolios affect market prices. Armed with this insight, we start with the basic version of the CAPM. We also show how some assumptions of the simple version may be relaxed to allow for greater realism. 258