Capital Asset Pricing Model (CAPM)

Definition§

The Capital Asset Pricing Model (CAPM) is a financial theory that establishes a linear relationship between the expected return on an asset and its systematic risk, as measured by beta. The formula for CAPM is:

$$\text{E}(R_i) = R_f + \beta_i [\text{E}(R_m) - R_f]$$

where:

• $\text{E}(R_i)$ = Expected return on asset $i$
• $R_f$ = Risk-free rate
• $\beta_i$ = Beta of the asset $i$
• $\text{E}(R_m)$ = Expected return of the market

Examples§

1. Stock Investment: If the risk-free rate $R_f$ is 3%, the expected market return $E(R_m)$ is 8%, and the beta ($\beta$) of the stock is 1.5, then the expected return on the stock using CAPM would be calculated as follows: $$E(R_i) = 0.03 + 1.5 \times (0.08 - 0.03) = 0.105 \text{ or } 10.5$$

2. Bond Valuation: Suppose a corporate bond has a beta of 0.7, with the risk-free rate at 2% and expected market return at 7%. Then the expected return on the bond is: $$E(R_i) = 0.02 + 0.7 \times (0.07 - 0.02) = 0.055 \text{ or } 5.5$$

Frequently Asked Questions§

What is Beta in CAPM?§

Beta measures the volatility, or systematic risk, of a security or a portfolio compared to the market as a whole. A beta of 1 indicates that the security’s price will move with the market. A beta greater than 1 indicates greater volatility than the market, while a beta less than 1 indicates less volatility.

What Does the Risk-Free Rate Represent?§

Risk-Free Rate (R_f) represents the return of an investment with zero risk, typically associated with government bonds like U.S. Treasury bills.

How Does CAPM Help Investors?§

CAPM helps investors assess whether a security is fairly valued, by comparing the expected return calculated by CAPM with the actual return. If the actual return is higher than the CAPM expected return, the security may be undervalued.

What Are the Limitations of CAPM?§

• It assumes investors can borrow and lend at the risk-free rate.
• The model relies on historical data for Beta, which may not accurately predict future risk.
• It assumes markets are perfectly competitive and all investors have the same expectations.

Related Terms§

• Systematic Risk: The risk inherent to the entire market or market segment.
• Unsystematic Risk: The risk unique to a specific company or industry.
• Alpha: A measure of performance on a risk-adjusted basis.
• Sharpe Ratio: A measure for calculating risk-adjusted return, comparing the return of an investment to its risk.

Online References§

1. Investopedia CAPM Article
2. Khan Academy - Capital Asset Pricing Model (CAPM)
3. Corporate Finance Institute CAPM Guide

Suggested Books for Further Studies§

• “Investments” by Zvi Bodie, Alex Kane, and Alan J. Marcus: Offers a comprehensive introduction to the principles of finance, including CAPM.
• “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen: Provides detailed insights into corporate finance concepts including risk management and asset pricing.
• “Modern Portfolio Theory and Investment Analysis” by Edwin J. Elton, Martin J. Gruber, Stephen J. Brown, and William N. Goetzmann: Covers modern financial theory and empirical evidence, including CAPM.

Accounting Basics: “Capital Asset Pricing Model (CAPM)” Fundamentals Quiz§

Thank you for exploring the Capital Asset Pricing Model with us and taking our sample quiz. Keep refining your financial acumen!