15.3 The Capital Asset Pricing Model (CAPM)
3 min read•june 18, 2024
The ###capital_asset_pricing_model_()_0### is a key tool for estimating expected returns based on risk. It uses the , , and an asset's to calculate potential returns. This model helps investors understand the relationship between risk and reward.
CAPM builds on , which focuses on and efficient portfolios. By considering and market movements, CAPM provides a framework for pricing assets and making investment decisions in a market context.
Capital Asset Pricing Model (CAPM)
Calculation of risk premium
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- represents the additional return an investor requires to compensate for the risk associated with an investment
- Determined by subtracting the from the on the investment
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- Expected return represents the anticipated average return an investor expects to earn from an investment over a given period (S&P 500 index)
- Risk-free rate is the return on an investment considered to have zero risk, often based on the yield of government bonds (U.S. Treasury bills)
- refers to the risk premium associated with the overall market
- Calculated by subtracting the risk-free rate from the expected return on the
Beta as systematic risk measure
- quantifies the sensitivity of an asset's returns to fluctuations in the broader market
- represents the risk inherent to the entire market that cannot be eliminated through (interest rate changes, inflation)
- Assets with beta > 1 exhibit higher volatility compared to the market
- Returns tend to amplify market movements in both positive and negative directions (technology stocks)
- Assets with beta < 1 display lower volatility relative to the market
- Returns tend to be more muted compared to market movements in both positive and negative directions (utility stocks)
- Assets with beta = 1 are expected to move in tandem with the market (market index funds)
- In the CAPM framework, beta is employed to estimate an asset's expected return based on its exposure to systematic risk
- The graphically represents the relationship between beta and expected return
CAPM for expected return
- CAPM is a model that estimates the expected return of an asset based on its systematic risk measured by beta
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- The expected return on the asset equals the risk-free rate plus a risk premium proportional to the asset's beta
- The market risk premium is determined by subtracting the risk-free rate from the expected market return
- An asset's expected return increases in a linear fashion with its beta
- Assets with higher betas command higher expected returns to compensate investors for bearing greater systematic risk (small-cap stocks)
- CAPM operates under the assumption that specific to individual assets can be mitigated through diversification
- Investors are only rewarded for assuming systematic risk captured by beta (market risk)
Modern Portfolio Theory and CAPM
- Modern portfolio theory forms the foundation for CAPM
- The represents the set of optimal portfolios that offer the highest expected return for a given level of risk
- Diversification helps reduce portfolio risk without sacrificing expected returns
- The market portfolio is a theoretical portfolio containing all risky assets in the market, weighted by their market capitalization
Key Terms to Review (27)
Beta: Beta measures the volatility or systematic risk of a security or portfolio relative to the overall market. A beta greater than 1 indicates more volatility than the market, while a beta less than 1 indicates less volatility.
Beta: Beta is a measure of the volatility or systematic risk of a financial asset or portfolio in relation to the overall market. It represents the sensitivity of an asset's returns to changes in the market's returns, providing a quantitative assessment of an investment's risk profile.
Capital Asset Pricing Model: The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between the expected return of an asset and its risk. It provides a framework for understanding how the market values an asset based on its systematic risk, which is measured by the asset's beta. CAPM is a fundamental concept in finance that is widely used in investment analysis, portfolio management, and corporate finance decision-making.
Capital asset pricing model (CAPM): The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between systematic risk and expected return for assets, particularly stocks. It is widely used to estimate an investment's required rate of return based on its risk relative to the market portfolio.
Capital Asset Pricing Model (CAPM): The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between the expected return of an asset and its risk. It is used to price risky securities and to determine the appropriate required rate of return for assets given their risk.
CAPM: 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.
CAPM Equation: The Capital Asset Pricing Model (CAPM) equation is a fundamental tool in finance that describes the relationship between an asset's expected return and its risk. It provides a framework for estimating the required rate of return for an investment based on its systematic risk, known as beta.
Diversification: Diversification involves spreading investments across various financial assets to reduce risk. It aims to minimize the impact of any single asset's poor performance on an overall investment portfolio.
Diversification: Diversification is the practice of investing in a variety of assets to reduce the overall risk of a portfolio. It involves spreading investments across different asset classes, industries, and geographic regions to minimize the impact of any single investment's performance on the overall portfolio.
Efficient Frontier: The efficient frontier is a concept in finance that represents the set of optimal portfolios, where each portfolio offers the maximum expected return for a given level of risk or the minimum risk for a given level of expected return. It is a crucial tool for understanding and optimizing the risk-return tradeoff in investment decisions.
Expected Return: The expected return is the anticipated or average return an investor expects to receive on an investment or asset over a given period of time. It is a crucial concept in the context of understanding risk and return, as well as the application of the Capital Asset Pricing Model (CAPM) to evaluate the performance of investments.
Market Portfolio: The market portfolio is a theoretical portfolio that represents all the investable assets in the market, weighted by their market capitalization. It is a key concept in the Capital Asset Pricing Model (CAPM) and the evaluation of the costs of debt and equity capital.
Market risk premium: The market risk premium is the additional return expected by investors for taking on the higher risk of investing in the stock market over a risk-free asset. It is a key component in determining the cost of equity using the Capital Asset Pricing Model (CAPM).
Market Risk Premium: The market risk premium is the additional return that investors expect to receive for holding a diversified portfolio of risky assets, such as stocks, rather than a risk-free asset like government bonds. It represents the compensation investors demand for taking on the additional risk of investing in the overall market.
MarketWatch: MarketWatch is a financial news website that provides business news, analysis, and stock market data. It is widely used by investors to track market trends and make informed investment decisions.
Modern Portfolio Theory: Modern Portfolio Theory (MPT) is a framework for analyzing and constructing investment portfolios. It focuses on maximizing expected portfolio returns for a given level of risk, or minimizing risk for a desired level of return, by diversifying investments across different asset classes and securities.
Risk premium: Risk premium is the return above the risk-free rate that investors demand for taking on additional risk. It compensates investors for the potential variability in returns from a risky asset compared to a risk-free asset.
Risk Premium: The risk premium is the additional return that investors expect to receive as compensation for taking on the higher risk associated with a particular investment. It represents the extra yield that investors demand to hold riskier assets compared to safer, less volatile investments.
Risk-free rate: The risk-free rate is the theoretical return on an investment with zero risk of financial loss. It typically represents the interest rate on short-term government securities, like U.S. Treasury bills, considered free from default risk.
Risk-Free Rate: The risk-free rate is the theoretical rate of return of an investment with zero risk. It represents the interest rate on an asset considered to have no default risk, such as U.S. Treasury bills. This rate is a critical component in various financial models and concepts, including the Discounted Cash Flow (DCF) Model, the Capital Asset Pricing Model (CAPM), the costs of debt and equity capital, and the Weighted Average Cost of Capital (WACC).
Security Market Line (SML): The Security Market Line (SML) is a graphical representation of the Capital Asset Pricing Model (CAPM), which describes the relationship between the expected return of an asset and its systematic risk, as measured by beta. The SML illustrates the trade-off between risk and return in the market, providing a benchmark for evaluating the performance of individual securities or portfolios.
Systematic risk: Systematic risk is the risk inherent to the entire market or a market segment. It cannot be eliminated through diversification and is influenced by factors such as economic changes, political events, and natural disasters.
Systematic Risk: Systematic risk, also known as market risk or undiversifiable risk, is the risk inherent to the entire market or market segment, which cannot be mitigated through diversification. It is the risk that affects all assets and cannot be eliminated by holding a diversified portfolio.
Unsystematic Risk: Unsystematic risk, also known as diversifiable or idiosyncratic risk, refers to the risk that is specific to an individual asset or a small group of assets. It is the portion of an asset's total risk that is not related to overall market movements or systematic factors, and can be reduced or eliminated through diversification.
US Department of the Treasury: The US Department of the Treasury is a federal agency responsible for managing government revenue, producing currency, and formulating economic policy. It plays a crucial role in maintaining the financial stability of the country.
US Treasury Securities: US Treasury Securities are debt instruments issued by the US Department of the Treasury to finance government spending. They include Treasury bills, notes, and bonds with varying maturities and interest rates.
Yahoo! Finance: Yahoo! Finance is a comprehensive financial news and data platform that provides up-to-date information on stock markets, economic indicators, and personal finance. It also offers tools for tracking investments and analyzing market trends.