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What is the 'Capital Asset Pricing Model - CAPM'

The capital asset pricing model is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating costs of capital.

BREAKING DOWN 'Capital Asset Pricing Model - CAPM'

The formula for calculating the expected return of an asset given its risk is as follows:

Capital Asset Pricing Model (CAPM)

The general idea behind CAPM is that investors need two forms of compensation: time value of money and risk. The risk-free rate in the formula represents the time value of money and compensates the investors for placing money in any investment over time. The risk-free rate is customarily the yield on government bonds like U.S. Treasuries.

The other half of the CAPM formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. You can calculate this by taking a risk measure (beta) that compares the returns of the asset to the market over time and to the market premium (Rm-rf): the return of the market in excess of the risk-free rate. Beta reflects how risky an asset is compared to overall market risk and is a function of the volatility of the asset and the market, and the correlation between the two. For stocks, the S&P 500 usually represents the market, but more robust indexes can represent it too.

The CAPM model says 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).

Example of Capital Asset Pricing Model

Using the CAPM model and the following assumptions, we can compute the expected return for a stock:

The risk-free rate is 2 percent, and the beta (risk measure) of a stock is 2. The expected market return over the period is 10 percent, so that means that the market risk premium is 8% (10% - 2%) after subtracting the risk-free rate from the expected market return. Plugging in the preceding values into the CAPM formula above, we get an expected return of 18 percent for the stock:

18% = 0.18 = 0.02 + [2 x (0.10 - 0.02)]

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

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