Capital asset pricing model
The Capital Asset Pricing Model (CAPM) is a financial model that determines the expected return on an investment based on its risk compared to the overall market. It helps investors evaluate the potential risk and return of a specific investment and make informed decisions about their portfolio.
The formula for CAPM is as follows:
Expected Return = Risk-Free Rate + Beta * (Market Return – Risk-Free Rate)
Where:
- Risk-Free Rate is the return on an investment with zero risk, such as a U.S. Treasury bond
- Beta measures the volatility of an investment compared to the overall market
- Market Return is the expected return on the overall market
For example, let’s say the risk-free rate is 2%, the beta of a stock is 1.2, and the expected market return is 8%. Using the CAPM formula, the expected return on the stock would be:
Expected Return = 2% + 1.2 * (8% – 2%) = 9.6%
By using the CAPM, investors can determine whether an investment is adequately compensating them for the risk they are taking on. It is an important tool in modern portfolio theory and is widely used in the finance industry.
For more information about the Capital Asset Pricing Model, you can visit Wikipedia.