Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk, or the general perils of investing, and expected return for assets, particularly stocks. It is a finance model that establishes a linear relationship between the required return on an investment and risk.
CAPM is based on the relationship between an asset's beta, the risk-free rate (typically the Treasury bill rate), and the equity risk premium, or the expected return on the market minus the risk-free rate.
CAPM evolved as a way to measure this systematic risk. It is widely used throughout finance for pricing risky securities and generating expected returns for assets, given the risk of those assets and cost of capital.
Definition: The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return on assets, particularly stocks. It is a financial model that establishes a linear relationship between the required return on an investment and its risk. CAPM is based on the relationship between an asset's beta coefficient, the risk-free rate (usually the yield on government bonds), and the equity risk premium (i.e., the market's expected return minus the risk-free rate).
Origin: CAPM was independently developed by William Sharpe, John Lintner, and Jan Mossin in the 1960s. Sharpe's 1964 paper, "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk," is considered foundational to CAPM. The model was introduced to better understand and measure systematic risk in investments.
Categories and Characteristics: CAPM has several key characteristics:
- Beta Coefficient: Measures the volatility of an individual asset relative to the overall market. A beta greater than 1 indicates higher volatility than the market, while a beta less than 1 indicates lower volatility.
- Risk-Free Rate: Typically represented by the yield on government bonds, as these are considered risk-free investments.
- Equity Risk Premium: The market's expected return minus the risk-free rate, reflecting the compensation investors require for taking on additional market risk.
Specific Cases:
- Case 1: Suppose a stock has a beta coefficient of 1.2, a risk-free rate of 2%, and a market expected return of 8%. According to the CAPM formula, the expected return = 2% + 1.2*(8%-2%) = 9.2%. This means investors expect a 9.2% return from this stock.
- Case 2: An investment portfolio has a beta coefficient of 0.8, a risk-free rate of 3%, and a market expected return of 10%. According to the CAPM formula, the expected return = 3% + 0.8*(10%-3%) = 8.6%. This indicates that investors expect an 8.6% return from this portfolio.
Common Issues:
- CAPM assumes that markets are fully efficient, which is not always the case in reality. Markets may have information asymmetry and other non-systematic risks.
- CAPM assumes that investors only care about expected return and risk. In reality, investors may also consider other factors such as liquidity and investment horizon.
