The capital asset pricing model

We saw, towards the end of Chapter 8, that finding an optimal portfolio using portfolio theory requires a computer program and a rather large variance-covariance matrix. This has hindered general acceptance of portfolio theory, despite its usefulness. We also saw, in the section called ‘Size of Optimal Portfolio’, that however much we diversify and however many securities are included in the portfolio, risk cannot be reduced, using a naïve diversification policy, to less than a certain amount. This is because as we hold more and more securities, we end up holding the whole stock market, and thus bearing the risk of that stock market, which cannot be diversified away. This concept of undiversifiable market risk, as it is known, is fundamental to the development of the more rigorous capital asset pricing model (or CAPM), which is described in this chapter. The CAPM shows that the risk of any security can be divided into two parts — the element which reflects that undiversifiable market risk and an element which is specific to the share and which can be diversified away when the share is held as part of a large portfolio.