CAPM

Definition

The Capital Asset Pricing Model (CAPM) is a financial model that establishes a linear relationship between the expected return of an asset and its systematic risk, as measured by beta. This model is used to determine a theoretically appropriate required rate of return of an asset, factoring in the risk-free rate and the expected market return. It serves as a fundamental concept in modern finance, connecting risk and return to investment decisions and pricing of assets.

5 Must Know Facts For Your Next Test

1. CAPM was developed by William Sharpe in the 1960s and remains a foundational theory in finance for evaluating risk and return.
2. The formula for CAPM is: Expected Return = Risk-free Rate + Beta × (Market Return - Risk-free Rate).
3. CAPM assumes that investors hold diversified portfolios and are primarily concerned with systematic risk, rather than total risk.
4. A key implication of CAPM is that an asset's expected return is directly proportional to its systematic risk, suggesting that higher risk leads to higher expected returns.
5. While widely used, CAPM has been criticized for its assumptions, such as the existence of a risk-free rate and that markets are efficient.

Review Questions

• How does CAPM relate expected return to systematic risk for an investment?
  • CAPM establishes that the expected return on an investment is determined by its systematic risk, represented by beta. The model quantifies this relationship through the formula: Expected Return = Risk-free Rate + Beta × (Market Return - Risk-free Rate). This means that higher beta values, indicating greater sensitivity to market movements, lead to higher expected returns, reflecting the risk-return tradeoff fundamental to investment theory.
• Discuss the assumptions made by CAPM and their implications for real-world application.
  • CAPM is based on several key assumptions including that investors can diversify their portfolios to eliminate unsystematic risk, that markets are efficient, and that there exists a risk-free rate of return. These assumptions imply that investors will only require compensation for bearing systematic risk. However, these ideal conditions rarely hold true in reality; therefore, while CAPM provides a useful framework for understanding risk and return, it may not accurately reflect actual market behavior or pricing under varying conditions.
• Evaluate the relevance of CAPM in contemporary financial analysis despite its limitations.
  • Despite criticisms regarding its assumptions and limitations, CAPM remains relevant in contemporary financial analysis as it provides a simplified approach to understanding the relationship between risk and expected return. Financial analysts and investors often use CAPM as a benchmark for assessing whether an asset is fairly valued relative to its risk. Furthermore, it helps in portfolio optimization and capital budgeting decisions. As finance continues to evolve, adaptations and alternative models have emerged, but CAPM still serves as a foundational reference point for evaluating investment performance.

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 change when the market moves.

Risk-free rate: The theoretical return on an investment with zero risk, typically represented by government bonds, used as a baseline in calculating expected returns.

Market Portfolio: A theoretical portfolio that contains all risky assets in the market, weighted by their market value, serving as a benchmark for assessing the performance of individual investments.