# capital asset pricing model

Also found in: Medical, Acronyms, Wikipedia.

## 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.

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)

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.

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.

Farlex Financial Dictionary. © 2012 Farlex, Inc. All Rights Reserved

## capital asset pricing model

a model that relates the expected return on an ASSET or INVESTMENT to its risk. Assets that show greater variability in their annual returns generally need to earn higher expected average returns to compensate investors for the variability of returns. See RISK AND UNCERTAINTY.Collins Dictionary of Economics, 4th ed. © C. Pass, B. Lowes, L. Davies 2005

Want to thank TFD for its existence? Tell a friend about us, add a link to this page, or visit the webmaster's page for free fun content.

Link to this page: