The Capital Asset Pricing Model (CAPM) provides a way to calculate the expected return of an investment based on the time value of money and the systematic risk of the asset. Put simply, CAPM estimates the price of a high-risk stock by linking the relationship between the risk of the stock and the expected return.
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CAPM is very commonly used in finance to price risky securities and calculating an expected return on those assets when considering the risk and cost of capital.
For more detailed information about the Capital Asset Pricing Model, including formulas and calculators, you can read our CAPM lesson here.
Frequently Asked Questions
What is the capital asset pricing model?
The capital asset pricing model (CAPM) is a tool used to measure the risk and expected return of an investment. CAPM calculates the price of a high-risk stock by linking the relationship between the risk of the stock and the expected return.
What is the CAPM formula?
The CAPM formula is as follows:
ERi = Rf + βi (ERm−Rf)
where:
ERi = expected return of investment
Rf = risk-free rate
βi = beta of the investment
(ERm−Rf) = market risk premium
What does CAPM mean for investors?
CAPM means that the expected return of an investment is a function of its systematic risk (beta) and the risk-free rate. Investors can use CAPM to price risky securities and calculate an expected return on those assets when considering the risk and cost of capital.
What is the Capital Asset Pricing Model CAPM based on?
CAPM is based on the theory of rational expectations, which states that investors are assumed to make informed and intelligent choices about securities. This theory underlies most financial models.
The model also uses the principles of Modern Portfolio Theory to determine how to best allocate an investment portfolio.
Is CAPM a good model?
CAPM is a good model for estimating the expected return of an investment, but it is not perfect. The model assumes that investors are rational and make informed choices about securities. It also assumes that investors can measure risk accurately. These assumptions may not always be accurate in practice.
For example, in the real world, investors may not be able to accurately measure the risk of a security. They may also make irrational choices about investments.