Modern portfolio theory began with the postulation of Capital Asset Pricing Model (CAPM). It provides how a risky security is priced in competitive capital market. It is the theory of equilibrium between risk and return. It postulates a positive and linear relationship between risk and return, and maintains that non-market risk successively declines with the process of diversification. The study examines the monthly return of composite portfolio of 100 stocks of BSE 100 for the period from June 1996 to May 2005. It involves the testing of relationship between risk and return of stocks of 100 companies and a set of ten portfolios. The empirical findings are in favor of the model by asserting a positive and linear relationship between risk and return. The study also reports that as diversification is carried out, non-market risks successively decline. These findings support CAPM in Indian stock market in establishing a trade-off between risk and return.

The mean-variance model of Markowitz (1952), establishes a positive relationship between risk and return. It is the cornerstone of modern finance theory and a powerful tool for effective allocation of wealth in different investment alternatives. Sharpe (1964), Lintner (1965), and Mossin (1966) further extend Markowitz's work by integrating the return of a stock with the return of market. The value of market portfolio fluctuates with the fluctuations in market. The modern Capital Asset Pricing Model (CAPM) is extensively used to address many practical problems in a number of areas of finance including asset pricing, cost-benefit analysis, portfolio formulation, and to measure the performance of a security and portfolio. One of its important applications is construction of market portfolio for investors.

This paper examines the relevance of CAPM in the Indian stock market, whether it is a suitable measure to determine the expected rate of return of a security. CAPM suggests that formulation of portfolio is an effective measure of diversification of portfolio risk. Diversification eliminates non-market risk which results in decline of total portfolio risk. Markowitz (1952) argues that portfolio risk is not simply weighted average risk of individual securities but it is an aggregation of covariability of the return of different securities in the portfolio.

Applied Finance Journal, Capital Asset Pricing Model, CAPM, Indian Stock Market, portfolio Management, Indian capital Market, Bombay Stock Exchange, BSE, Risk Management, Regression Analysis, Global Economy, Security Market Line, Capital Management, Financial Management, Capital Asset Market.