Capital Asset Pricing Model

Definition

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. It is a financial model that establishes a linear relationship between the required return on an investment and its risk.

Origin

CAPM was developed in the 1960s by financial scholars William Sharpe, John Lintner, and Jan Mossin. It is based on Harry Markowitz's Modern Portfolio Theory and aims to provide investors with a method to measure asset risk and expected return.

Categories and Features

The core of CAPM is its formula: Expected Return = Risk-Free Rate + Beta × (Market Expected Return - Risk-Free Rate). Here, the beta coefficient measures an asset's volatility relative to the market. CAPM assumes that markets are efficient, investors are rational, and there are no transaction costs.

Case Studies

Case 1: Suppose a company's stock has a beta of 1.2, a risk-free rate of 3%, and a market expected return of 8%. According to CAPM, the expected return for this stock is 3% + 1.2 × (8% - 3%) = 9%. Case 2: Another company's stock has a beta of 0.8 under the same conditions, resulting in an expected return of 3% + 0.8 × (8% - 3%) = 7%. These calculations help investors assess the risk-adjusted returns of different stocks.

Common Issues

Investors often misunderstand the assumptions of CAPM, such as market efficiency and investor rationality. Additionally, CAPM may underestimate or overestimate risk and return under actual market conditions, especially during high market volatility.