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Copyright © 2012, Campbell R. Harvey. All Rights Reserved.

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)


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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References in periodicals archive ?
Organization with limited resources are more willing to use a cost of equity capital, which is decided by "what investors identify to us that they need executives with MBA's are commonly practice only one factor capital asset pricing model or the CAMP with additional risk factor than that of non MBA executives, but the distinction is only important for the one factor capital asset pricing model CAPM".13
Sharpe (1964) formulated CAPM (Capital Asset Pricing Model), whose foundation is the deduction that the efficient portfolio would be the market portfolio itself.
Similarly, in another study conducted by Iqbal and Brooks (2007), to test the validity of CAPM on PSX and found a nonlinear relationship of risk and return, intensively in recent period because of the market performance supported by intensive trading activity and elevated level of liquidity.
Section III considers the effects of the choice of market portfolio proxy on CAPM estimated market betas and costs of equity of the 30 Fama-French industry portfolios.
Under the assumption that the CAPM is correctly specified, the equity market integration hypothesis implies that a two-factor model should be rejected in favor of the CAPM.
CAPM is one of the most important and debatable topic of modern finance.
Butt and Virk (2015) use the proportion of the zero-returns illiquidity measure, in addition to the Amihud (2002) illiquidity ratio, to report evidence that a substantial risk premium related to illiquidity risk exists in the Finnish market, and that a liquidity-adjusted CAPM performs better than simple CAPM specifications.
For example, Godfrey and Espinosa (1996) suggested two main modifications of traditional United States (US) cost of equity calculation based on CAPM that should be made for emerging countries.
The Capital Asset Pricing Model (CAPM) is the most prevalent model for determination of equity returns in the developed countries.