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.





 Rf + βi[E(Rm) – Rf]






 the expected return on asset i




 the risk-free rate of return




 the expected return on the market portfolio




 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.