Capital Asset Pricing Model (CAPM)
Expected return equals risk-free rate plus beta times the market risk premium.
CAPM is the foundation of modern finance: it says the expected return on an asset equals the risk-free rate plus a risk premium proportional to the asset's systematic risk (beta). Formula: E[R] = Rf + β×(Rm − Rf). Example: If Rf = 3%, market return (Rm) = 10%, and a stock's beta = 1.3, expected return = 3% + 1.3×(10%−3%) = 12.1%. Key insight: Only systematic risk (beta) is rewarded — idiosyncratic risk can be diversified away. Uses: Estimating cost of equity for DCF, evaluating risk-adjusted performance (alpha), portfolio construction. Criticisms: Assumes investors hold the market portfolio, single-period model, beta is stable (empirically false). Despite flaws, CAPM remains the dominant framework for cost of equity.
Efficient Frontier
The set of portfolios offering the highest return for each level of risk.
Sharpe Ratio
Risk-adjusted return: excess return divided by volatility.
Covariance Matrix
Captures how asset returns move together — the foundation of diversification.
Portfolio Volatility
Standard deviation of portfolio returns — total risk including diversification effects.
Minimum Variance Portfolio
The portfolio with the lowest possible volatility.
Maximum Sharpe Portfolio
The portfolio with the highest risk-adjusted return.