Capital Asset Pricing Model

Capital asset pricing model (CAPM)

An economic theory that describes the relationship between risk and expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification. The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security plus a risk premium multiplied by the asset's systematic risk. Theory was invented by William Sharpe (1964) and John Lintner (1965). The early work of Jack Treynor is was also instrumental in the development of this model.

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Capital Asset Pricing Model

A model that attempts to describe the relationship between the risk and the expected return on an investment that is used to determine an investment's appropriate price. The assumption behind the CAPM is that money has two values: a time value and a risk value. Thus, any risky asset or investment must compensate the investor for both the time his/her money is tied up in the investment and the investment's relative riskiness. This compensation must be in addition to the risk-free rate of return. There are a number of variations on the CAPM, notably the multifactor CAPM and the two-factor model. The CAPM is calculated according to the following formula:

ra = rf + Betaa(rm - rf)

where:

ra is the asset price,
rf is the risk-free rate of return,
Betaa is the risk premium, and

rm is the market rate of return.

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Capital Asset Pricing Model (CAPM)

What Does Capital Asset Pricing Model (CAPM) Mean?

A model that describes the relationship between risk and expected return; it is used to price securities. The general idea behind CAPM is that investors need to be compensated for investing their cash in two ways: (1) time value of money and (2) risk. (1) The time value of money is represented by the risk-free (rf) rate in the formula and compensates investors for placing money in any investment over period of time. (2) Risk calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

Investopedia explains Capital Asset Pricing Model (CAPM)

The CAPM states that the expected return of a security or a portfolio should equal the rate on a risk-free security (a U.S. Treasury bond) plus a risk premium. If this expected return does not meet or exceed the required return, the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Using the CAPM model with the following assumptions, one can compute the expected return of a stock: If the risk-free rate = 3%, the beta (risk measure) of the stock = 2, and the expected market return over the time period = 10%, the stock is expected to return 17% (3% + 2(10% -3%)).

Related Terms:
• Beta
• Security Market Line—SML
• Treasury Bill—T-Bill
• Capital Market Line—CML
• Systematic Risk