What is capital asset pricing model?

Capital asset pricing model will allow you to split the total risk that is associated with the security into proportions. One of the proportion remains after diversification and the other may be diversified away. The risk which remains even after diversification is a relevant risk for appraising investment.

Initially substantial reduction of risks takes place, but with more and more diversification, the risk reduction slows down and eventually it stops at a point.

With capital asset pricing model, you can clearly detect the risk that is involved with the security you are providing. The risk that can be eliminated using the capital asset pricing model is termed as non systematic risk. The non systematic risk in fact affects the returns on your investment in a very unique way.

Investors are mainly worried about the systematic risk which affects the complete return on the investment. Now the problem is how to calculate the amount of systematic risk. Capital asset pricing model measure the systematic risk taking in to account two base points- the market portfolio and the risk free security.


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