capital-asset pricing model


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capital-asset pricing model (CAPM)

A mathematical model for securities pricing in which the relative riskiness of securities is combined with the return on risk-free assets. This model, which uses beta, the widely used measure of risk, has been criticized; nevertheless, it is considered a very important element of modern investment and portfolio theory. See also capital market line.
Capital-asset pricing modelclick for a larger image
Fig. 15 Capital-asset pricing model. This identifies the market risk factor for the expected rate of investment.

capital-asset pricing model

a share price valuation model in which the major factors of short-term share-price determination are explained. The capital-asset pricing model provides a method of computing the return on a FINANCIAL SECURITY which specifically identifies and measures the risk factor within a PORTFOLIO holding. The expected rate of return on a particular investment has two components:
  1. the risk-free percentage return which could be obtained from, say, a gilt-edged, government financial security;
  2. the risk return associated with the investment. (Risk itself can be split into market or nondiversifiable risk and specific or diversifiable risk.) This relationship between risk and return is shown in Fig. 15.

The total expected return on an investment is orm, but risk only attaches to non gilt-edged securities which is why the capital market line intercepts the vertical axis at rf. The capital market line shows how, in a competitive market, the additional risk premium varies in direct proportion to β. known as the BETA COEFFICIENT. At point M in the figure there is perfect correlation between movements in the market generally as detailed by an all-share index, and a particular investment. Therefore β= 1 at point M. Where there is no risk, as in Treasury bills, β= 0. β is a measure of market risk because investors have it within their power to diversify away specific risk to almost zero by holding a broad portfolio of shares. It is possible to estimate the beta coefficient of a security from published information.

See also EFFICIENT MARKETS HYPOTHESIS, PORTFOLIO THEORY.