The Capital Asset Pricing Model

CAPM & the Efficient Frontier

Using the CAPM to build a portfolio is designed to help an investor manage their risk. The optimal portfolio can be identified using an efficient frontier, similar to the situation with modern portfolio theory. 

Portfolios are plotted on a graph, with the expected return on the Y-Axis and standard deviation on the X-Axis. A line called the Capital Market Line is drawn from the risk-free rate to the efficient frontier. 

In the CAPM, the optimal portfolio, in terms of expected return and expected risk, can be identified in the place where the Capital Market Line almost touches the efficient frontier. 

Both the Capital Market Line and the efficient frontier illustrate to investors that there is a trade-off between increased return and increased risk. 

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