Finance, Economics, and Mathematics

Chapter 21Introduction to Part V

The Capital Asset Pricing Model (CAPM) represented a significant step in the development of modern finance theory. It rested on Markowitz's concept of risk as the volatility of price, and on the ideas of mean-variance portfolio optimization, but it went a step further: It made a statement about the market, under the assumption that investors optimize their individual holdings. By postulating that the part of stock volatilities that are not correlated with the market portfolio (the specific risks) are mutually sufficiently independent to be diversified away, the model derives its powerful tenet: The risk of a security consists of two parts: the systematic risk and the specific risk. Systematic risk, measured by the covariance of the security price with the market portfolio price, carries a compensation in terms of expected return premium. The specific risk is not compensated for, since it can be reduced by diversification. Quantitatively, this is expressed by the equation for the capital market line,

where is the expected rate of return on the i–th security, is the expected rate of return on the market portfolio, is the regression coefficient of ...