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What is the Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) is a financial framework used to determine the expected return of an investment based on its risk relative to the overall market.
Definition
The Capital Asset Pricing Model (CAPM) is a formula that calculates the expected return of an asset by combining the risk‑free rate, the asset’s sensitivity to market risk (beta), and the market risk premium.
Key Takeaways
- Links risk and expected return in a single formula.
- Helps investors evaluate whether an asset is fairly valued.
- Beta measures an asset’s volatility relative to the market.
- Assumes markets are efficient and investors are rational.
Understanding the Capital Asset Pricing Model (CAPM)
CAPM is one of the foundational models in modern finance. It provides a simple method for calculating the return an investor should expect as compensation for the risk of holding a particular asset.
The model assumes:
- Investors need to be compensated for time value of money (risk‑free rate).
- Investors need additional compensation for taking on risk (market risk premium).
Beta measures how an asset moves compared to the broader market:
- Beta > 1: More volatile than the market.
- Beta < 1: Less volatile than the market.
- Beta = 1: Moves with the market.
Formula
Expected Return = Risk‑Free Rate + Beta × (Market Return − Risk‑Free Rate)
Real-World Example
If:
- Risk‑free rate = 3%
- Market return = 10%
- Asset beta = 1.2
Then:
Expected Return = 3% + 1.2 × (10% − 3%) = 3% + 1.2 × 7% = 11.4%
Importance in Business or Economics
- Used in valuing stocks, portfolios, and capital budgeting projects.
- Helps determine discount rates in DCF valuation.
- Provides a benchmark for evaluating investment performance.
- Supports efficient portfolio construction.
Types or Variations
- Single‑Factor CAPM
- Multi‑Factor Models (e.g., Fama–French)
- Levered vs. Unlevered Beta
- Conditional CAPM
Related Terms
- Beta
- Market Risk Premium
- Weighted Average Cost of Capital (WACC)
- Efficient Frontier
Sources and Further Reading
- CFA Institute – Portfolio Management
- Investopedia – CAPM
- Journal of Finance – Asset Pricing Theory
Quick Reference
- Purpose: Estimate expected return.
- Inputs: Risk‑free rate, beta, market premium.
- Best For: Portfolio analysis + valuation.
Frequently Asked Questions (FAQs)
Why is CAPM useful?
It provides a simple, widely used way to estimate expected returns and discount rates.
Is CAPM accurate in real markets?
It can be limited—real markets include irrational behavior and multiple risk factors.
What is beta in CAPM?
A measure of an asset’s volatility relative to the market.
