Capital Asset Pricing Model (CAPM)
Quick Definition
A foundational financial model that describes the relationship between systematic risk (beta) and expected return for an asset.
What Is Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) is one of the most important models in finance. It states that the expected return of any investment should be the risk-free rate plus a premium for the systematic risk (beta) taken.
The CAPM Formula: Expected Return = Rf + β × (Rm - Rf)
Where:
- Rf = Risk-free rate (Treasury yield)
- β = Beta (systematic risk measure)
- Rm = Expected market return
- (Rm - Rf) = Market risk premium (equity risk premium)
CAPM Calculation Examples:
| Stock | Beta | Rf | Rm | Expected Return |
|---|---|---|---|---|
| Low-risk utility | 0.5 | 4% | 10% | 4% + 0.5(6%) = 7% |
| Market (S&P 500) | 1.0 | 4% | 10% | 4% + 1.0(6%) = 10% |
| Growth tech stock | 1.5 | 4% | 10% | 4% + 1.5(6%) = 13% |
| High-risk startup | 2.0 | 4% | 10% | 4% + 2.0(6%) = 16% |
CAPM Assumptions:
- Markets are efficient
- Investors are rational and risk-averse
- All investors have the same expectations
- No taxes or transaction costs
- Unlimited borrowing at the risk-free rate
Strengths and Limitations:
| Strengths | Limitations |
|---|---|
| Simple and intuitive | Over-simplified (single-factor) |
| Establishes risk-return framework | Beta isn't stable over time |
| Foundation for cost of equity | Doesn't explain small-cap or value premiums |
| Widely used in corporate finance | Assumptions are unrealistic |
Beyond CAPM: The Fama-French 3-factor model adds size and value factors. The 5-factor model adds profitability and investment. These explain returns better than CAPM alone, but CAPM remains the foundational starting point.
Formula
Formula
E(Ri) = Rf + βi × (E(Rm) - Rf)Capital Asset Pricing Model (CAPM) Example
- 1Using CAPM: if the risk-free rate is 4%, market premium is 6%, and Apple's beta is 1.2, expected return = 4% + 1.2(6%) = 11.2%
- 2CAPM is used in corporate finance to calculate cost of equity for DCF valuations
Related Terms
Beta (β)
A measure of a stock's volatility relative to the overall market, where a beta of 1.0 means the stock moves in line with the market, above 1.0 means more volatile, and below 1.0 means less volatile.
Equity Risk Premium
The excess return that investing in the stock market provides over the risk-free rate, compensating investors for bearing equity market risk.
Risk-Free Rate
The theoretical return on an investment with zero risk, typically represented by short-term US Treasury yields, serving as the baseline for all other return expectations.
Security Market Line
A graphical representation of the CAPM showing the expected return of investments at different levels of systematic risk (beta).
Standard Deviation
A statistical measure of how spread out returns are from the average, quantifying investment volatility and risk.
Risk Management
The systematic process of identifying, assessing, and mitigating financial risks to protect portfolio value and achieve investment objectives.
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