Financial Concepts: Capital Asset Pricing Model (CAPM)
  1. Financial Concepts: Introduction
  2. Financial Concepts: The Risk/Return Tradeoff
  3. Financial Concepts: Diversification
  4. Financial Concepts: Dollar Cost Averaging
  5. Financial Concepts: Asset Allocation
  6. Financial Concepts: Random Walk Theory
  7. Financial Concepts: Efficient Market Hypothesis
  8. Financial Concepts: The Optimal Portfolio
  9. Financial Concepts: Capital Asset Pricing Model (CAPM)
  10. Financial Concepts: Conclusion

Financial Concepts: Capital Asset Pricing Model (CAPM)


Pronounced as though it were spelled "cap-m", this model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe. The capital asset pricing model (CAPM) describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities.

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 our required return, the investment should not be undertaken.


The commonly used formula to describe the CAPM relationship is as follows:

Required (or expected) Return = RF Rate + (Market Return - RF Rate)*Beta

For example, let's say that the current risk free-rate is 5%, and the S&P 500 is expected to return to 12% next year. You are interested in determining the return that Joe's Oyster Bar Inc (JOB) will have next year. You have determined that its beta value is 1.9. The overall stock market has a beta of 1.0, so JOB's beta of 1.9 tells us that it carries more risk than the overall market; this extra risk means that we should expect a higher potential return than the 12% of the S&P 500. We can calculate this as the following:

Required (or expected) Return = 5% + (12% - 5%)*1.9
Required (or expected) Return = 18.3%

What CAPM tells us is that Joe's Oyster Bar has a required rate of return of 18.3%. So, if you invest in JOB, you should be getting at least 18.3% return on your investment. If you don't think that JOB will produce those kinds of returns for you, then you should consider investing in a different company.

It is important to remember that high-beta shares usually give the highest returns. Over a long period of time, however, high beta shares are the worst performers during market declines (bear markets). While you might receive high returns from high beta shares, there is no guarantee that the CAPM return is realized.

Financial Concepts: Conclusion

  1. Financial Concepts: Introduction
  2. Financial Concepts: The Risk/Return Tradeoff
  3. Financial Concepts: Diversification
  4. Financial Concepts: Dollar Cost Averaging
  5. Financial Concepts: Asset Allocation
  6. Financial Concepts: Random Walk Theory
  7. Financial Concepts: Efficient Market Hypothesis
  8. Financial Concepts: The Optimal Portfolio
  9. Financial Concepts: Capital Asset Pricing Model (CAPM)
  10. Financial Concepts: Conclusion
RELATED TERMS
  1. Capital Asset Pricing Model - CAPM

    A model that describes the relationship between risk and expected ...
  2. International Capital Asset Pricing Model (CAPM)

    A financial model that extends the concept of the capital asset ...
  3. Beta

    Beta is a measure of the volatility, or systematic risk, of a ...
  4. Roll's Critique

    An economic idea that suggests that it is impossible to create ...
  5. International Beta

    Better known as "global beta", international beta is a measure ...
  6. Consumption Capital Asset Pricing Model - CCAPM

    A financial model that extends the concepts of the capital asset ...
RELATED FAQS
  1. What is the formula for calculating the capital asset pricing model (CAPM)?

    Learn about the capital asset pricing model, or CAPM, and how this formula is used to determine the expected rate of return ... Read Answer >>
  2. 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 >>
  3. 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 >>
  4. How do I calculate the cost of equity using Excel?

    Learn how to calculate the cost of equity in Microsoft Excel using the capital asset pricing model, or CAPM, including brief ... Read Answer >>
  5. How does market risk affect the cost of capital?

    Find out how market risk directly affects the total cost of capital, including how to use the capital asset pricing model ... Read Answer >>
  6. How accurate is the equity risk premium in evaluating a stock?

    Learn about the drawbacks of using the equity risk premium to evaluate a stock, and understand how it is calculated using ... Read Answer >>

You May Also Like

Hot Definitions
  1. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  2. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  3. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  4. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  5. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  6. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
Trading Center