Capital Asset Pricing Model - Research Paper Example

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Capital Asset Pricing Model

"As a result, investors choose "mean-variance-efficient" portfolios, in the sense that the portfolios: 1) minimize the variance of portfolio return, given expected return, and 2) maximize expected return, given variance. Thus, the Markowitz approach is often called a "mean-variance model" (Eugene F. Fama).
This figure gives a clear picture of the CAPM. Its horizontal axis shows the portfolio risk which is measure by the standard deviation of portfolio return. Its vertical axis is the expected return. The curve is the minimum variance frontier which "traces the combination of expected return and variance at different levels of expected return" (Eugene F. Fama). This shows the obvious trade-off between risk and expected return.
"At point T, the investor can have an intermediate expected return with lower volatility. If there is no risk free borrowing or lending, only portfolios above b along abc are mean-variance-efficient, since these portfolios also maximize expected return, given their return variances" (Eugene F. Fama).
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Whenever a company invests in a new project or when an investor invests in some shares, there is always some risk involved (unless the investment is made in risk-free securities such as "gilts"). However, a company can also reduce its overall exposure to such investment-related risk if it invests in a number of projects with the view that even if the more risky projects perform badly, the less risky projects will cover up for the loss, resulting in an average return from the portfolio that is pretty much closer to what company expects i.e…
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