Capital asset pricing model (CAPM)

Definition

The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between systematic risk and expected return for assets, particularly stocks. It is widely used to estimate an investment's required rate of return based on its risk relative to the market portfolio.

5 Must Know Facts For Your Next Test

1. CAPM formula: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate).
2. Beta measures an asset's volatility relative to the market; a beta of 1 means the asset moves with the market.
3. The risk-free rate typically represents government bonds or Treasury bills.
4. CAPM assumes investors hold diversified portfolios, eliminating unsystematic risk.
5. Critics argue that CAPM relies on several unrealistic assumptions, such as investors having homogeneous expectations and markets being frictionless.

Review Questions

• What does Beta represent in the CAPM formula?
• How does CAPM define the relationship between risk and expected return?
• List one major assumption underlying the CAPM.

Related terms

Risk-Free Rate: The return on an investment with zero risk, often represented by government bonds.

Beta: A measure of an asset's volatility in relation to the overall market.

Market Portfolio: A theoretical portfolio comprising all available assets in the market, weighted by their market values.