Capital Asset Pricing Model - CAPM

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What is the 'Capital Asset Pricing Model - CAPM'

The capital asset pricing model (CAPM) is a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

Capital Asset Pricing Model (CAPM)

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

BREAKING DOWN 'Capital Asset Pricing Model - CAPM'

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

Wants to know more about CAPM? Read Taking Shots at CAPM and The Capital Asset Pricing Model: An Overview

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    A. the covariance between the stock and the market. B. the variance of the market. C. the market risk premium. D. ... Read Answer >>
  3. How do I use the CAPM (capital asset pricing model) to determine the cost of equity?

    Learn about the elements of the capital asset pricing model, and discover how to use this formula to calculate a business' ... Read Answer >>
  4. How is the Capital Asset Pricing Model (CAPM) represented in the Security Market ...

    Learn about the capital asset pricing model and the security market line and how the model is used in the calculation and ... Read Answer >>
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  6. What is the correlation between equity risk premium and risk?

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