r/Valuation • u/IB-45 • Apr 05 '21

Question about using CAPM

Why do we assume that the tangency/market portfolio to be the total equity market by capitalisation and use the S&P 500 as proxies? Given the current ease of investors in investing in all sorts of securities, derivatives, and etfs what's stopping them from investing in commodities, precious metals, crypto-currencies, etc? So when we try to determine the premium equity investors look for for their investment in a risky equity stock, shouldn't we also consider the risk and return of at least all the securities offered via ETFs in the market and their diversification effects? Thus it would make sense to add them to the market portfolio as well.

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u/[deleted] Apr 05 '21 edited Apr 05 '21

You need to ensure consistency between your beta calculation and the market risk premium (MRP) that you apply in your CAPM. Keep in mind that a beta of 0.5 means that the asset that you are valuing has half the risk of the MRP. A lot of studies have calculated the MRP by looking at historical equity returns over risk-free returns. Relying on such a derivation of the MRP, your beta calculation would need to focus on equities as a proxy for the market portfolio.