Capital asset pricing model

Definition

The capital asset pricing model (CAPM) is a financial model that establishes a relationship between the expected return of an investment and its risk, measured by beta. It helps investors understand the trade-off between risk and return in international portfolio investment by estimating the expected return based on the risk-free rate, the expected market return, and the systematic risk of the asset. CAPM is essential for making informed investment decisions across different markets and currencies.

5 Must Know Facts For Your Next Test

1. CAPM provides a formula: Expected return = Risk-free rate + Beta * (Expected market return - Risk-free rate).
2. The model assumes that investors hold diversified portfolios, thus only systematic risk (market risk) is relevant for pricing assets.
3. In international portfolio investment, CAPM can be adapted to account for different currencies and geopolitical risks.
4. CAPM is widely used in finance for asset valuation, performance evaluation, and capital budgeting decisions.
5. Limitations of CAPM include assumptions of market efficiency and investor rationality, which may not hold true in all situations.

Review Questions

• How does the capital asset pricing model help investors assess the risk versus return when investing internationally?
  • The capital asset pricing model assists investors by providing a framework to evaluate expected returns based on an asset's systematic risk, represented by beta. In the context of international investment, it helps quantify how much additional return an investor should expect for taking on higher levels of risk compared to a risk-free asset. This allows investors to make more informed decisions about where to allocate their resources across various markets.
• Discuss the significance of beta in the capital asset pricing model and how it influences investment decisions in a global context.
  • Beta is crucial in CAPM as it quantifies an asset's risk relative to the market. A beta greater than 1 indicates that an asset is more volatile than the market, while a beta less than 1 suggests it is less volatile. In a global context, understanding beta helps investors identify which assets may react more strongly to changes in global economic conditions or market fluctuations, thereby guiding them towards investments that align with their risk tolerance.
• Evaluate the implications of CAPM's assumptions about market efficiency and investor behavior for international portfolio management.
  • The assumptions of market efficiency and rational investor behavior underlying CAPM imply that all available information is reflected in asset prices. However, if these assumptions do not hold true, it can lead to mispricing and inefficiencies in international markets. This can affect portfolio management strategies since managers may need to rely on alternative models or adjustments to CAPM to account for behavioral biases and market anomalies when making investment decisions across diverse economies.

Related terms

Beta: A measure of an asset's volatility in relation to the overall market, indicating how much the asset's price is expected to change in response to market movements.

Risk-free rate: The return on an investment with zero risk, often represented by government bonds, which serves as a baseline for evaluating other investments.

Expected market return: The anticipated return of a market portfolio, which serves as a benchmark against which individual assets' returns are compared.