Capital asset pricing model

Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a widely used financial model that helps investors determine the expected return on an investment based on its risk. It was developed by William Sharpe in the 1960s and has since become a cornerstone of modern portfolio theory.

Overview

The CAPM is based on the principle that investors require compensation for taking on additional risk. It assumes that investors are rational and risk-averse, seeking to maximize their returns while minimizing their risk exposure. The model calculates the expected return of an investment by considering its beta, which measures its sensitivity to market movements.

Formula

The CAPM formula is as follows:

Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

In this formula, the risk-free rate represents the return on a risk-free investment, such as a government bond. The market return refers to the overall return of the market, typically represented by a broad-based index such as the S&P 500. Beta measures the volatility of an investment relative to the market.

Internal Links

The CAPM can be further understood by exploring the following concepts:

• Risk-Free Rate: Learn more about the risk-free rate and its importance in the CAPM formula.
• Beta: Understand how beta is calculated and its role in determining the expected return of an investment.
• Modern Portfolio Theory: Discover how the CAPM fits into the broader framework of modern portfolio theory.

Categories

The CAPM falls under the following categories:

• Financial Models: Explore other financial models used in investment analysis and portfolio management.
• Investment Theory: Learn about different theories and concepts related to investments and asset pricing.

Templates

The following templates can be used to enhance articles related to the CAPM:

Use this template to provide a general overview of finance-related topics.

Apply this template to articles specifically focused on investment-related subjects.

Conclusion

The Capital Asset Pricing Model is a valuable tool for investors to assess the expected return on an investment based on its risk. By considering factors such as the risk-free rate, beta, and market return, investors can make more informed decisions about their portfolio allocations. Understanding the CAPM and its underlying principles is crucial for anyone involved in financial analysis and investment management.