ts in terms of their effects on the investor's portfolio. As a result, these models take the point of view of the investor, and suggest that the investor should be concerned with the contribution that a given investment will make to the existing portfolio. This modern portfolio theory (MPT), as it was originally known, evolved as modifications and additions were made. The capital asset pricing model, also called the beta model because of its name for the measure of risk, is a derivation of the MPT.
The CAPM is widely used and increasingly discussed. It is a version of a risk-premium model which assigns increasingly high returns for increasing risks. In this way, an investment with the lowest possible return would be an investment with no risk. The return on this risk-free investment compensates the investor for the illiquidity (having the invested funds unavailable) for the life of the investment.
Since the CAPM is an extension in mathematics and logic of the MPT, it is helpful to understand the process associated with the MPT in order to understand the CAPM. Using MPT techniques to calculate the risk of a portfolio requires the standard deviations of every asset's expected returns, the correlation between the expected returns for every pair of assets, and the amount of each asset being held. This is a cumbersome process when there is a small number of assets, and a nearly impossible process if the number of assets is quite large (Groth, 1992, p. 4).
One way to simplify the process is to correlate each asset's expected return with the expected return of a weighted average or index of all assets under consideration. If, for example, the assets were only 20 stocks, 20 standard deviations would need to be calculated along with 20 correlations of the expected returns from each asset with the expected returns from the new index, consisting of 20 stocks. This results in 40 calculations where the MPT model would require a to...