Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a financial theory used to determine the expected return on an investment based on its risk relative to the market. It calculates the expected return by considering the risk-free rate, the investment’s sensitivity to market movements (beta), and the expected market return. CAPM helps investors assess whether a stock is fairly valued by comparing its expected return to its risk level.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a financial theory used to determine the expected return on an investment based on its risk relative to the market. It calculates the expected return by considering the risk-free rate, the investment’s sensitivity to market movements (beta), and the expected market return. CAPM helps investors assess whether a stock is fairly valued by comparing its expected return to its risk level.
💡 Key Takeaways
- Understand the CAPM formula E(Ri) = Rf + beta_i [E(Rm) – Rf] and what each term represents.
- Interpret beta as a measure of a security's sensitivity to market movements and what different beta values imply for risk and return.
- Learn how CAPM informs the required return on an investment and the cost of equity, guiding project appraisal and portfolio decisions.
- Be aware of CAPM's assumptions and limitations, including market efficiency, stable beta, and the focus on systematic risk.
❓ Frequently Asked Questions
What is the Capital Asset Pricing Model (CAPM)?
CAPM is a finance model that links an asset's expected return to its risk relative to the overall market. It uses the risk-free rate, the asset's beta, and the expected market return to estimate the required return.
What are the main components of CAPM?
Risk-free rate (Rf), beta (β) which measures sensitivity to market moves, and the market risk premium (E(Rm) − Rf), which is the extra return investors demand for taking market risk.
What does beta represent in CAPM?
Beta shows how much an asset's returns tend to move with the market. A beta greater than 1 means higher volatility than the market; less than 1 means lower volatility.
How is the expected return calculated in CAPM?
E(Ri) = Rf + βi [E(Rm) − Rf], where E(Ri) is the asset's expected return, Rf is the risk-free rate, βi is the asset's beta, and E(Rm) − Rf is the market risk premium.