CAPM

Definition

The Capital Asset Pricing Model (CAPM) is a financial model used to determine the expected return on an investment, taking into account its risk in relation to the market. CAPM connects the concept of risk and return, where the expected return on an asset is equal to the risk-free rate plus a risk premium based on the asset's beta, which measures its sensitivity to market movements. This model is fundamental for assessing the cost of capital and helps investors make informed decisions by evaluating whether an investment is worth the risk compared to its expected returns.

5 Must Know Facts For Your Next Test

1. CAPM establishes a linear relationship between the expected return of an asset and its systematic risk as measured by beta.
2. The formula for CAPM is: $$E(R_i) = R_f + \beta_i(E(R_m) - R_f)$$, where $$E(R_i)$$ is the expected return of the investment, $$R_f$$ is the risk-free rate, and $$E(R_m)$$ is the expected market return.
3. A higher beta indicates higher risk and, therefore, a higher expected return, while a lower beta suggests lower risk and potentially lower returns.
4. CAPM assumes that investors hold diversified portfolios that eliminate unsystematic risk, meaning they are only concerned with systematic risk reflected in beta.
5. The model relies on several assumptions including market efficiency, rational behavior among investors, and a single period investment horizon.

Review Questions

• How does CAPM relate expected returns to systematic risk, and why is this relationship important for investors?
  • CAPM establishes that the expected return on an investment is directly proportional to its systematic risk as measured by beta. This relationship is crucial for investors because it allows them to quantify the risk-return trade-off of their investments. By understanding how much additional return they should expect for taking on extra risk, investors can make more informed choices about their portfolios and capital allocation.
• Discuss how changes in the risk-free rate can impact the expected returns predicted by CAPM.
  • Changes in the risk-free rate can significantly impact the expected returns derived from CAPM because it acts as the baseline for all other returns. When the risk-free rate increases, it raises the expected return for all assets since investors now require a higher compensation for taking on additional risks. Conversely, if the risk-free rate falls, the expected returns from investments also decrease, which can lead to shifts in investor behavior and asset pricing in the market.
• Evaluate the assumptions behind CAPM and how deviations from these assumptions could affect its applicability in real-world scenarios.
  • CAPM relies on several assumptions like market efficiency, rational investor behavior, and that all investors have access to identical information. In reality, markets are often influenced by irrational behaviors, asymmetric information, and external shocks which can lead to deviations from these assumptions. Such deviations may reduce CAPM's accuracy in predicting actual returns as real-world investments may not always reflect a purely rational decision-making process or perfectly efficient markets. As a result, alternative models or adjustments may be needed to account for these complexities.

Related terms

Beta: A measure of an asset's volatility in relation to the overall market, indicating how much the asset's price is expected to move compared to market movements.

Risk-Free Rate: The theoretical return on an investment with zero risk, typically represented by government bonds, which serves as a baseline for evaluating other investments.

Expected Return: The anticipated return on an investment, calculated using historical data and models like CAPM, which factors in risk and market performance.