Assume that you own one factory among many that is selling a particular type of colored egg to many smart egg traders. It would make sense for you to assume that your egg traders are smart, that they like to buy eggs in colors that have high expected rates of return, but that they also like to buy some eggs that are di?erent and unique. In other words, you should assume that your traders do the same optimal basket stocking calculations that we have just gone through. You can even work out how much smart egg traders would be willing to pay for eggs of your factory’s color. If your egg color is very di?erent from those of the other eggs in traders’ baskets, you can charge more for your eggs than if your eggs are very much like the rest of their eggs. In equilibrium, there should be a relationship—the most unusual-colored eggs should command higher prices and thereby earn egg traders lower expected rates of return, but egg traders still like them because of the insurance such eggs o?er them, within reasonable bounds, of course.
For stocks, this model is called the CAPM. It says that stocks that earn high rates of returns when the (market) portfolio of other stocks does poorly are more desirable, therefore priced higher, and therefore o?er a lower expected rate of return. And this is what we are ultimately really after. As corporate executives, we want to know how our investors are valuing our projects. If our projects earn our investors money when the rests of their portfolio are doing poorly, then our investors will want us to take these projects on their behalves even if our projects have a (reasonably mildly) low expected rate of return. In ?nance-speak, we should use a lowercost of capital for these projects, because they have lower market-betas—market-beta being a measure of the similarities of our projects’ rates of return with those of other investments in the market. The CAPM gives us the precise formula that relates the market beta to the cost of capital, because it presumes that it can work out exactly what smart egg traders (market investors) like and dislike.