Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a financial model that determines the expected return of an asset based on its risk.

CAPM states that the expected return of an asset is equal to the risk-free rate of return plus a risk premium. The risk premium is the additional return that investors demand for bearing the risk of the asset. The risk premium is calculated as the product of the asset’s beta and the market risk premium.

Beta is a measure of the asset’s volatility relative to the market. A beta of 1 means that the asset’s returns move in perfect correlation with the market. A beta of greater than 1 means that the asset is more volatile than the market, and a beta of less than 1 means that the asset is less volatile than the market.

The market risk premium is the difference between the expected return of the market and the risk-free rate of return. The market risk premium is a measure of the additional return that investors demand for bearing the risk of the market.

Questions

• What is the Capital Asset Pricing Model (CAPM)?
• What are the assumptions of CAPM?
• How is the expected return of an asset calculated using CAPM?

Answers

• The Capital Asset Pricing Model (CAPM) is a financial model that determines the expected return of an asset based on its risk.
• The assumptions of CAPM are:
  * Investors are risk averse.
  * Investors can borrow and lend at the risk-free rate.
  * All investors have the same information.
  * Assets are perfectly divisible.
  * There are no taxes.
• The expected return of an asset using CAPM is calculated as follows:

  “`
  Expected Return = Risk-free Rate + Beta * Market Risk Premium
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