Capital Asset Pricing Model - CAPM

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Dictionary Says

Definition of 'Capital Asset Pricing Model - CAPM'

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).
Investopedia Says

Investopedia explains '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%)).

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Articles Of Interest

  1. The Capital Asset Pricing Model: An Overview

    CAPM helps you determine what return you deserve for putting your money at risk.

  2. How Risk Free Is The Risk-Free Rate Of Return?

    This rate is rarely questioned - unless the economy falls into disarray.

  3. Taking Shots At CAPM

    Find out why many investors think the capital asset pricing model is full of holes.

  4. Catch On To The CCAPM

    The consumption capital asset pricing model smoothes over some of CAPM's weaknesses to make sense of risk aversion.

  5. Understanding The Sharpe Ratio

    This simple ratio will tell you how much that extra return is really worth.

  6. DCF Analysis: Calculating The Discount Rate

    Learn how to determine what past cash flows are worth today.

  7. Financial Concepts: Capital Asset Pricing Model (CAPM)

    Find out which shares to avoid during a bear market.

  8. Behavioral Finance: Background

    Take a general look at behavioral finance and the main contributors to this field of study.

  9. Reduce Your Risk With ICAPM

    Avoid unnecesary risks involved in CAPM calculations by also incorporating ICAPM into the mix.

  10. Beta: Know The Risk

    Beta says something about price risk, but how much does it say about fundamental risk factors? Find out here.
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