Series 65: Capital Asset Pricing Model

Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a model that builds on the ideas of modern portfolio theory, allowing investors to calculate the expected return on an investment given the amount of systematic risk of the investment.

To understand CAPM, it is important to understand the distinction between systematic and unsystematic risk. Recall that systematic risk is risk attributable to market forces. In other words, it is the risk that the entire market will decline. Unsystematic risk is investment-specific. It is the risk that a particular investment will do poorly because of factors having to do with that investment alone (e.g., poor management, changes in regulation). Unsystematic risk can be diversified away by choosing the right set of uncorrelated or negatively correlated securities. Because unsystematic risk can be minimized through diversification, investors do not expect to be compensated for increased unsystematic risk. In contrast, systematic risk cannot be minimized through diversification, and for this reason, investors demand to be compensat