What is the Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) is a financial formula used to estimate the expected return on an investment based on its risk relative to the market. It’s a foundational concept in finance for assessing whether an asset is fairly valued based on potential risk and return.
Formula:
Expected Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)
Risk-Free Rate: Return of a zero-risk investment (e.g. government bonds)
Beta: Measure of an asset’s volatility compared to the overall market
Market Return: Expected return of the overall market
Why It’s Used:
To assess the attractiveness of investment opportunities
Helps portfolio managers manage risk and build diversified portfolios
Provides a benchmark for evaluating company cost of equity