Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is a model that can be used to calculate the expected return from an asset during a period in terms of the risk of the return. The risk in the return from an asset is divided into two parts. Systematic risk is risk related to the return from the market as a whole and cannot be diversified away. Nonsystematic risk is risk that is unique to the asset and can be diversified away by choosing a large portfolio of different assets. CAPM argues that the return should depend only on systematic risk.

CAPM

assumptions.

  1. Investors care only about the expected return and standard deviation of the return from an asset.
  2. The returns from two assets are correlated with each other only because of their correlation with the return from the market. This is equivalent to assuming that there is only one factor driving returns.
  3. Investors focus on returns over a single period and that period is the same for all investors.
  4. Investors can borrow and lend at the same risk-free rate.
  5. Tax does not influence investment decisions.
  6. All investors make the same estimates of expected returns, standard deviations of returns, and correlations between returns.

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