54 Frequently Asked Questions In Quantitative Finance
What is the Capital Asset Pricing
Model?
Short Answer
The Capital Asset Pricing Model (CAPM) relates the
returns on individual assets or entire portfolios to the
return on the market as a whole. It introduces the con-
cepts of specific risk and systematic risk.Specific risk
is unique to an individual asset,systematic riskis that
associated with the market. In CAPM investors are com-
pensated for taking systematic risk but not for taking
specific risk. This is because specific risk can be diver-
sified away by holding many different assets.
Example
A stock has an expected return of 15% and a volatility of
20%. But how much of that risk and return are related
to the market as a whole? Because the less that can
be attributed to the behaviour of the market then the
better that stock will be for diversification purposes.
Long Answer
CAPM simultaneously simplified Markowitz’s Modern
Portfolio Theory (MPT), made it more practical and
introduced the idea of specific and systematic risk.
Whereas MPT has arbitrary correlation between all
investments, CAPM, in its basic form, only links invest-
ments via the market as a whole.
CAPM is an example of an equilibrium model, as
opposed to a no-arbitrage model such as Black–Scholes.
The mathematics of CAPM is very simple. We relate the
random return on theith investment,Ri, to the random
