WHAT IS THE CAPITAL ASSET PRICING MODEL?

The Capital Asset Pricing Model incorporates a series of assumptions and theories about the nature of capital assets and how they are priced. One of the cornerstones of the CAPM is the identification of and distinction between systematic risk and unsystematic risk.

Unsystematic risk is the risk of a specific asset, which can be minimized by diversifying your portfolio so that we only need to concern ourselves with systematic risk. Systematic risk measures an asset's volatility in relation to the volatility of all other capital assets. The measurement of systematic risk is called beta.

The beauty of the CAPM is that it has given us a formula to measure expected returns based upon the systematic risk, or beta, of a given firm. A stock with a relatively high degree of systematic risk will have a relatively high expected return.

In the next section, you will learn the elements needed to calculate expected returns for individual stocks.