14 Capital Asset Pricing Model (CAPM)

Because investors are risk averse, they will choose to hold a portfolio of securities to take advantage of the benefits of Diversification. Therefore, when they are deciding whether or not to invest in a particular stock, they want to know how the stock will contribute to the risk and expected return of their portfolios.

The standard deviation of an individual stock does not indicate how that stock will contribute to the risk and return of a diversified portfolio. Thus, another measure of risk is needed; a measure of a security's systematic risk. This measure is provided by the Capital Asset Pricing Model (CAPM).

Systematic and Unsystematic Risk

An asset's total risk consists of both systematic and unsystematic risk.

Systematic risk, which is also called market risk or undiversifiable risk, is the portion of an asset's risk that cannot be eliminated via diversification. The systematic risk indicates how including a particular asset in a diversified portfolio will contribute to the riskiness of the portfolio

Unsystematic risk, which is also called firm-specific or diversifiable risk, is the portion of an asset's total risk that can be eliminated by including the security as part of a diversifiable portfolio.

The Capital Asset Pricing Model (CAPM) provides an expression which relates the expected return on an asset to its systematic risk. The relationship is known as the Security Market Line (SML) equation and the measure of systematic risk in the CAPM is called Beta.