Portfolio Theory & The Benefits of Diversification , Capital Asset Pricing Model (CAPM)

Portfolio Theory & The Benefits of Diversification

Chapter: 12 Portfolio Theory & The Benefits of Diversification

Section: 5 Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a model that relates the expected return to an asset based on its level of systematic (market-related) risk.

CAPM:

E(Ri)

Rf + βi[E(Rm) – Rf]

Where:

E(Ri)	=	the expected return on asset i

R_f	=	the risk-free rate of return

E(Rm)	=	the expected return on the market portfolio

Βi	=	Cov(Ri, Rm) / Var(Rm), the sensitivity of a security’s return to the market’s return

CAPM has a number of underlying assumptions:

Investors only need to know expected returns, variances, and covariances in order to create optimal portfolios.
All investors have the same forecasts of risky assets’ expected returns, variances, and covariances.
All assets are marketable, and the market for assets is perfectly competitive.
Investors can borrow and lend at the risk-free rate, and unlimited short selling is allowed.
There are no frictions to trading, such as taxes or transaction costs.

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