![]() Understanding Risk and ReturnĬentral to CAPM is the notion that a rational investor expects higher returns for taking on higher risk. The concept of the efficient frontier underpins CAPM by providing the groundwork for understanding the trade-off between risk and return. Each point on the frontier represents a distinct portfolio structure that has maximized returns for a given level of risk. Within MPT, the Efficient Frontier represents a set of optimal portfolios that offer the highest expected return for a defined level of risk. It emphasizes that the risk and return of a portfolio depend not just on individual asset characteristics, but also on how assets are correlated with each other. ![]() MPT proposes that investors can construct an ‘efficient’ portfolio to maximize expected returns for a given level of risk by diversifying their investments. Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952, provides the backdrop against which CAPM was developed. The Capital Asset Pricing Model (CAPM) finds its roots in the fundamental concepts of modern portfolio theory, efficient frontier, and the relationship between risk and return. The CAPM calculates the expected return by considering the risk-free rate of return, the asset’s beta (systematic risk), and the market risk premium. ![]() It assumes that investors are rational and risk-averse, markets are efficient, and all investors have the same expectations about future returns and risks.The Capital Asset Pricing Model (CAPM) is a financial model used to estimate the expected return on an investment based on its risk.
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