# Capital Asset Pricing Model

**Topics:**Capital asset pricing model, Investment, Financial markets

**Pages:**4 (1325 words)

**Published:**April 26, 2014

where E(rm) is the return on the market portfolio rf is the return on the riskless asset while σm is the risk of the market portfolio (described by its variance) All points of the efficient frontier - which is defined as the set of un-dominated portfolios of risky assets in the absence of the riskless asset - will be dominated by the Capital Markets Line except for the market portfolio ‘M’. This is referred to as the Two-fund separation theorem. Therefore, the agents will hold a combination of the market portfolio and the riskless asset, along the line of the Capital Markets line, where they can reach a high level expected return, while bearing the cost of a higher risk, through either consuming less of the riskless asset or even short-selling the riskless asset and buy more of the market portfolio from the proceeds, given their degree of risk aversion. This is demonstrated in the following diagram:

where agent I is the most risk averse holding a combination of the market portfolio and the riskless asset, agent II is only holding...

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