The Capital Asset Pricing Model (CAPM) is frequently used in portfolio management to determine the theoretically appropriate required rate of return on an asset, it relating the performance and price volatility of an individual asset or an asset portfolio to the overall market.
CAPM is used to distinguish systematic risk, which is the risk of a change in the price of all assets in the entire market or a market segment, from unsystematic risk, which is the price risk of each individual asset due to the unique circumstances of the asset. Systematic risk cannot be mitigated through diversification, whereas the unsystematic risk of a single asset can be reduced through portfolio diversification.
Portfolio risk is the risk that a portfolio of financial assets or units within individual group of assets will fail to meet investment objectives. It can be decomposed into systematic and unsystematic risk:
Portfolio Risk = Systematic Risk + Unsystematic Risk
The three components of the expected return on an asset are:
- Risk-free rate (Rf) – The theoretical rate of return of an asset with a systematic risk of zero, representing the return an investor would expect from an absolutely risk-free investment over a specified period of time;
- Market risk premium (Rm) – The excess return that an individual asset or the overall market provides over a risk-free rate, which it is the difference between the market rate and the risk-free rate (Rm − Rf); and
- Beta (ß) – A measure of an asset’s systematic risk in comparison to the market as a whole, where an asset with a coefficient of 1.0 denotes the same level of risk as the overall market and that its price will move in direct proportion to the market.
The formula for the expected rate of return on an investment (E) using CAPM is, where Rf is the risk-free rate, ß is beta, and Rm the market risk premium:
E = Rf + ß(Rm − Rf)