Our objective in this reading is to identify the optimal risky portfolio for all investors by using the capital asset pricing model (CAPM). The foundation of this reading is the computation of risk and return of a portfolio and the role that correlation plays in diversifying portfolio risk and arriving at the efficient frontier. The efficient frontier and the capital allocation line consist of portfolios that are generally acceptable to all investors. By combining an investor’s individual indifference curves with the market-determined capital allocation line, we are able to illustrate that the only optimal risky portfolio for an investor is the portfolio of all risky assets (i.e., the market).
Additionally, we discuss the capital market line, a special case of the capital allocation line that is used for passive investor portfolios. We also differentiate between systematic and nonsystematic risk, and explain why investors are compensated for bearing systematic risk but receive no compensation for bearing nonsystematic risk. We discuss in detail the CAPM, which is a simple model for estimating asset returns based only on the asset’s systematic risk. Finally, we illustrate how the CAPM allows security selection to build an optimal portfolio for an investor by changing the asset mix beyond a passive market portfolio.
The reading is organized as follows. In Section 2, we discuss the consequences of combining a risk-free asset with the market portfolio and provide an interpretation of the capital market line. Section 3 decomposes total risk into systematic and nonsystematic risk and discusses the characteristics of and differences between the two kinds of risk. We also introduce return-generating models, including the single-index model, and illustrate the calculation of beta by using formulas and graphically by using the security characteristic line. In Section 4, we introduce the capital asset pricing model and the security market line. We discuss many applications of the CAPM and the SML throughout the reading, including the use of expected return in making capital budgeting decisions, the evaluation of portfolios using the CAPM’s risk-adjusted return as the benchmark, security selection, and determining whether adding a new security to the current portfolio is appropriate. Our focus on the CAPM does not suggest that the CAPM is the only viable asset pricing model. Although the CAPM is an excellent starting point, more advanced readings expand on these discussions and extend the analysis to other models that account for multiple explanatory factors. A preview of a number of these models is given in Section 5, and a summary and practice problems conclude the reading.