The Capital Asset Pricing Model

CAPM & the Efficient Frontier

1

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.

2

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.

3

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.

4

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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