Loading the player...

What is the 'Capital Asset Pricing Model - CAPM'

The capital asset pricing model (CAPM) 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 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 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. 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): 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 as well as the correlation between the two. For stocks, the market is usually represented as the S&P 500 but can be represented by more robust indexes as well.

The CAPM model 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).

Example of Capital Asset Pricing Model (CAPM)

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

The risk-free rate is 2% and the beta (risk measure) of a stock is 2. The expected market return over the period is 10%, 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% for the stock:

18% = 2% + 2 x (10%-2%)

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

RELATED TERMS
  1. Market Risk Premium

    Market risk premium is the difference between the expected return ...
  2. Risk-Free Return

    Risk-free return is the theoretical return attributed to an investment ...
  3. Cost Of Equity

    The cost of equity is the rate of return required on an investment ...
  4. Country Risk Premium (CRP)

    Country risk premium (CRP) is the additional risk associated ...
  5. Fama and French Three Factor Model

    The Fama and French Three-Factor model expanded the CAPM to include ...
  6. Heteroskedastic

    Heteroskedastic refers to a condition in which the variance of ...
Related Articles
  1. Investing

    The Capital Asset Pricing Model: an Overview

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

    Capital Asset Pricing (CAPM) Model: Pros and Cons

    CAPM, while criticized for its unrealistic assumptions, provides a more useful outcome than either the DDM or WACC in many situations.
  3. Investing

    How Risk Free Is the Risk-Free Rate of Return?

    This rate is rarely questioned—unless the economy falls into disarray.
  4. Investing

    How to Calculate Risk Premium

    Think of a risk premium as a form of hazard pay for risky investments.
  5. Investing

    How to calculate required rate of return

    The required rate of return is used by investors and corporate-finance professionals to evaluate investments. In this article, we explore the various ways it can be calculated and put to use.
  6. Investing

    Beta: Know the Risk

    Beta says something about measuring price risk in stocks, but how much does it say about fundamental risk factors too?
  7. Investing

    Calculating The Equity Risk Premium

    See the model in action with real data and evaluate whether its assumptions are valid. Here is how to calculate the equity risk premium.
  8. Investing

    Understanding The Sharpe Ratio

    The Sharpe ratio describes how much excess return you are receiving for the extra volatility that you endure for holding a riskier asset.
RELATED FAQS
  1. How do I use the CAPM (capital asset pricing model) to determine cost of equity?

    Learn about the elements of the capital asset pricing model, and discover how to calculate a business' cost of equity financing ... Read Answer >>
  2. According to the CAPM, the expected return on a stock, that is part of a portfolio, ...

    A. the covariance between the stock and the market. B. the variance of the market. C. the market risk premium. D. ... Read Answer >>
  3. What is the formula for calculating the capital asset pricing model (CAPM) in Excel?

    Find out more about the capital asset pricing model (CAPM) and the formula for calculating it in Microsoft Excel. Read Answer >>
  4. Use market risk premium for expected market return

    Find out how the expected market return rate is determined when calculating market risk premium – and how to estimate investment ... Read Answer >>
Hot Definitions
  1. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  2. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  3. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  4. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  5. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  6. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
Trading Center