WHAT IS THE CAPITAL ASSET PRICING MODEL?
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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.
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
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.