Capital Asset Pricing Model (CAPM)

The capital asset pricing model provides a mathematical measure of investment risk and shows how diversification reduces investment risk.  The model offers a technique to calculate the total risk of a diversified portfolio based on: (1) the risk of the individual investments in the portfolio and (2) the degree of correlation in investment returns among the individual assets that comprise the investment.

CAPM is represented by the following equation:

E(R_j) = R_j + b_j[E(R_m) – R_f]

Where:

E(R_j) the expected rate of return on an asset j

R_f is the risk free rate of interest

b is the undiversifiable risk associated with the asset j

E(R_m) is the expected return on the market