Page 149 - A Canuck's Guide to Financial Literacy 2020

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Capital Asset Pricing Model

Capital Asset Pricing Model is a theory developed by economist William Sharpe in 1970 that
details the relationship between the expected return and the risk of investing in a particular
investment. The theory utilizes a formula that calculates the expected return of a security
based on its level of risk, detailed below.

His theory states that an investment contains two types of risk:

Systematic Risk

▪ Refers to market risk that affects all investors. It includes macroeconomic conditions,
inflation, interest rate changes and economic direction. Systematic risk cannot be
diversified.

Non-Systematic Risk
▪ Refers to risk that is unique to a business or industry. Adding low correlation funds
into your portfolio will allow you to fully diversify your portfolio. Modern Portfolio
Theory states that rational investors can eliminate non-systematic risk by
diversifying their portfolio.

Risk free rate is usually the yield on long term government bonds.