CAPM

Definition

The Capital Asset Pricing Model (CAPM) is a formula used to determine the expected return on an investment based on its systematic risk. It helps in understanding the relationship between risk and return in a well-diversified portfolio.

5 Must Know Facts For Your Next Test

1. The CAPM formula is E(Ri) = Rf + βi(E(Rm) - Rf), where E(Ri) is the expected return, Rf is the risk-free rate, βi is the beta, and E(Rm) is the expected market return.
2. Beta (β) measures an asset's volatility relative to the overall market.
3. CAPM assumes that investors hold diversified portfolios to eliminate unsystematic risk.
4. The Security Market Line (SML) represents CAPM graphically, showing the relationship between expected return and beta.
5. CAPM relies on several assumptions including markets are efficient and investors are rational.

Review Questions

• What does Beta (β) represent in the CAPM formula?
• How does CAPM help in understanding risk and return?
• What are some key assumptions of CAPM?

Related terms

Risk-Free Rate: The theoretical rate of return on an investment with zero risk of financial loss.

Beta (β): A measure of an asset's volatility or systematic risk compared to the overall market.

Security Market Line (SML): A graphical representation of the CAPM showing the relationship between expected return and beta.