Capital Asset Pricing Model (CAPM)

Abstract

The capital asset pricing model (CAPM) is the basic theory that links risk and return for all assets—it quantifies the relationship between risk and return. The aim of running the CAPM model is to identify systematic risk. Capital asset pricing model (CAPM) is an attempt to explain and quantify the non-diversifiable type of risk. In other words, it measures how much additional return an investor should expect from taking a little extra risk. Investors demand a premium for bearing risk and therefore the higher the risk of the security, the higher the expected return to encourage investors to buy that security. As investors hold well-diversified portfolios, they are concerned with the non-diversifiable part of the risk of an individual stock. The relevant risk of an individual stock is its contribution to the risk of a well-diversified portfolio. Nondiversifiable risk is the relevant portion of an asset’s risk attributable to market factors that affect all firms and which cannot be eliminated through diversification. Also called systematic risk. Because any investor can create a portfolio of assets that will eliminate virtually all diversifiable risk, the only relevant risk is the one that is non-diversifiable. International agencies use the same approach in order to identify the beta coefficient of different companies. The beta is used as measure to quantify the systematic risk.