Principles of Managerial Finance, 15th Edition

8.4 Risk and Return: The Capital Asset Pricing Model (CAPM)

1. LG5

2. LG6

Thus far, we have observed a tendency for riskier investments to earn higher returns, and we have learned that investors can reduce risk through diversification. Now we want to quantify the relationship between risk and return. In other words, we wish to measure how much additional return an investor should expect from taking a little extra risk. The classic theory that links risk and return for all assets is the capital asset pricing model (CAPM). We will use the CAPM to understand the basic risk–return tradeoffs involved in all types of financial decisions.

Types of Risk

In the last section, we saw that the standard deviation of a portfolio may be less than the standard ...