Capital Market Theory - CAPM and the Efficient Frontier › Capital Market Theory: CAPM and the Efficient Frontier

In the previous chapter, we developed Modern Portfolio Theory and the mean-variance optimization framework. We learned how investors can construct efficient portfolios that maximize expected return for a given level of risk, and how diversification reduces portfolio volatility. However, that analysis left several questions unanswered: How should assets be priced in equilibrium if all investors follow mean-variance optimization? What determines the appropriate expected return for bearing risk?

The Capital Asset Pricing Model (CAPM), developed independently by William Sharpe, John Lintner, and Jan Mossin in the 1960s, provides elegant answers to these questions. CAPM turns portfolio theory from a normative framework (what investors should do) into a positive model (what asset prices will be in equilibrium). The model's central insight is that only systematic risk, the risk that cannot be diversified away, should command a risk premium in the market.

CAPM introduces several concepts that have become foundational in finance: the market portfolio as the optimal risky portfolio, Beta as the measure of systematic risk, and Alpha as a measure of risk-adjusted performance. While subsequent research has revealed important limitations and anomalies, CAPM remains the starting point for understanding asset pricing and provides the benchmark against which we evaluate investment performance. The framework you learn in this chapter will serve as the foundation for multi-factor models covered in the next chapter on Arbitrage Pricing Theory.