Capital Asset Pricing Model

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, measured by beta. It is widely used to determine the appropriate required rate of return for an investment, helping investors understand how diversification and geographic factors can impact risk and return, as well as the evaluation of performance metrics like the Treynor ratio.

5 Must Know Facts For Your Next Test

1. CAPM calculates the expected return on an investment by adding the risk-free rate to the product of the asset's beta and the market risk premium.
2. The model highlights the importance of diversification by demonstrating that unsystematic risk can be reduced, leaving only systematic risk as relevant for determining expected returns.
3. Investors can use CAPM to assess whether an asset is fairly valued, overvalued, or undervalued based on its expected return versus its risk.
4. Geographic diversification can influence a portfolio's beta, as assets in different regions may have varying levels of systematic risk due to economic and political factors.
5. The Treynor ratio utilizes CAPM to evaluate performance by comparing excess returns earned per unit of risk, specifically using beta as a measure of systematic risk.

Review Questions

• How does CAPM inform investors about the relationship between risk and return when constructing a diversified portfolio?
  • CAPM helps investors understand that the expected return on an asset is directly related to its systematic risk, represented by beta. When constructing a diversified portfolio, investors can use CAPM to identify which assets offer adequate returns for their level of risk. By analyzing multiple assets and their betas, they can create a balanced portfolio that minimizes unsystematic risk while achieving targeted returns.
• Discuss the implications of geographic diversification on CAPM and how it affects an investor's expected returns.
  • Geographic diversification impacts CAPM by potentially altering the systematic risk associated with investments. Different regions may experience varied economic conditions, regulatory environments, and political stability, which can affect an asset's beta. Investors who diversify across geographic boundaries can potentially lower their overall portfolio risk while aiming for higher expected returns, making it essential to consider geographic factors when applying CAPM.
• Evaluate how the Treynor ratio uses CAPM to measure investment performance and why this is significant for investors.
  • The Treynor ratio leverages CAPM by comparing excess returns over the risk-free rate with the portfolio's beta, providing a measure of performance relative to systematic risk. This approach allows investors to assess how well an investment compensates them for taking on that risk. Understanding this relationship is significant because it guides investors in making informed decisions about asset allocation and helps them identify investments that deliver superior returns per unit of systematic risk.

Related terms

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

Market Risk Premium: The additional return expected by investors for taking on the risk of investing in the stock market compared to a risk-free asset.

Portfolio Theory: A theory that focuses on how investors can construct portfolios to maximize expected return based on a given level of risk through diversification.