Question

Discuss how CAPM can be used in practice to assist portfolio investment decisions.

Answer 1

CAPM (Capital Asset Pricing Model) incorporates the risk-return relationship. When an investor invest in a portfolio, there is a desire for a rate of return that compensates for the risk associated with that investment. There are two types of risk associated with portfolio investment

1. Systematic Risk - The Risk which cannot be eliminated i.e Market Risk, regardless of how much is the diversification of the portfolio

2. Unsystematic Risk - This risk can be eliminated by diversification of portfolio. This risk is also known as "specific risk," it represents the component of a stock's return that is not correlated with general market moves.

The CAPM model can be used to calculate the return required to compensate for the systematic risk present in portfolio investment as unsystematic can be removed through diversification.