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Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a financial model used to determine the expected return on an investment based on its risk relative to the overall market. CAPM calculates the expected return by considering the risk-free rate, the market’s expected return, and the investment’s beta (a measure of its volatility compared to the market). The formula for CAPM is: Expected Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate).

Example

If the risk-free rate is 3%, the expected market return is 8%, and a stock has a beta of 1.2, CAPM calculates the expected return on the stock as: 3% + 1.2 × (8% – 3%) = 9%.

Key points

• CAPM determines the expected return on an investment based on its risk relative to the market.

• It uses the risk-free rate, market return, and beta to calculate the expected return.

• Helps investors assess risk and return to make better investment decisions.

Quick Answers to Curious Questions

CAPM measures the expected return on an investment based on its risk (beta) and the difference between the market return and the risk-free rate.

Beta measures the volatility of an investment relative to the market. A higher beta indicates greater risk and, therefore, a higher expected return according to CAPM.

It helps investors assess whether an investment offers a return that justifies its risk, guiding decisions on asset allocation.