10.3. The Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a common tool for structuring your thinking about the relationship between risk and return. There are several concepts that are crucial to an understanding of the capital asset pricing model. First among them is the distinction between systematic and nonsystematic risk. You’ll recall that systematic risk is risk attributable to market forces. Nonsystematic risk is company-specific. Nonsystematic risk can be diversified away by owning uncorrelated or negatively correlated securities. Systematic risk is not diversifiable. The capital asset pricing model supports the idea that a diversified portfolio of securities can reduce nonsystematic risk to zero.

Second is the concept of excess return. Excess return is the return derived from both s