Capital Asset Pricing Model (CAPM)

Definition§

The Capital Asset Pricing Model (CAPM) is a financial model that quantifies the expected rate of return on an investment based on its systematic risk, often measured by beta. The model establishes a linear relationship between the expected return of an asset, the risk-free rate of return, and the expected return of the market, allowing investors to evaluate the fair return for taking on additional risk.

CAPM vs. Other Financial Models§

Formula§

The formula for the Capital Asset Pricing Model is expressed as:

$$E(R_i) = R_f + \beta_i \cdot (E(R_m) - R_f)$$

Where:

• $E(R_i)$ = Expected return of the investment
• $R_f$ = Risk-free rate (e.g., the yield on Treasury bonds)
• $\beta_i$ = Beta of the investment (a measure of volatility compared to the market)
• $E(R_m)$ = Expected return of the market

Example§

Suppose the risk-free rate is 2%, the expected return of the market is 8%, and a specific stock has a beta of 1.5. Plugging these values into the CAPM formula gives us:

$$E(R_i) = 2$$

That means, according to CAPM, you should expect an 11% return on that stock!

Humor and Fun Facts§

• Funny Quote: “Investing is like a marriage: you’ll have your ups and downs, but hopefully you end up getting a bigger return!”
• Fun Fact: The CAPM was developed by financial theorists William Sharpe, John Lintner, and Jack Treynor around the 1960s. So just like vinyl records, it’s got a vintage vibe!

Related Terms§

• Beta: A measure of an asset’s volatility in relation to the market.
• Alpha: The excess return an investment earns above the benchmark return.
• Risk-Free Rate: The return on an investment with no risk of financial loss, typically government bonds.

Frequently Asked Questions§

What is beta in CAPM?§

Beta measures an asset’s sensitivity to market movements. A beta greater than 1 indicates more volatility than the market, while a beta less than 1 indicates less.

Is CAPM still relevant today?§

Yes! Despite its limitations, CAPM remains a staple for capital budgeting and investment analysis, helping investors simplify complex decisions about risk and return.

What are the limitations of CAPM?§

CAPM assumes markets are efficient and investors have the same expectations about the future, which isn’t always true. It also relies on historical data for beta, which may not accurately predict future returns.

Can CAPM be used for all assets?§

While CAPM is primarily designed for risky securities, it’s best suited for diversified portfolios. Individual asset returns may not strictly follow CAPM predictions.

References and Further Reading§

• Investopedia’s Guide to CAPM
• “The Intelligent Investor” by Benjamin Graham for insights on risk management.
• “Security Analysis” by Benjamin Graham and David Dodd for deeper financial theories.

Test Your Knowledge: Capital Asset Pricing Model (CAPM) Quiz§

Thank you for diving into the world of CAPM! May your returns shine brighter than your calculator! 🚀