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Capital Asset Pricing Model

Capital Asset Pricing Model.webp

Key Highlights

  • CAPM is a widely used financial framework that explains the relationship between expected return and risk of an investment.

  • Expected Return (Re) = Risk-Free Rate (Rf) + Beta (β) × [Market Return (Rm) – Risk-Free Rate (Rf)]

What is Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a widely used financial framework that explains the relationship between expected return and risk of an investment. It provides a formula to calculate the expected return on a security by considering the risk-free rate, the security’s sensitivity to market movements (beta), and the expected market return.

CAPM Formula

Expected Return (Re) = Risk-Free Rate (Rf) + Beta (β) × [Market Return (Rm) – Risk-Free Rate (Rf)]

Where:

  • Risk-Free Rate (Rf): Return on a risk-free asset, such as government securities.

  • Beta (β): A measure of a security’s volatility relative to the overall market.

  • Market Return (Rm): Expected return from the market portfolio.

Key Assumptions of CAPM

  • Investors are rational and risk-averse.

  • Markets are efficient, and all investors have equal access to information.

  • There are no transaction costs or taxes.

  • Returns are normally distributed over time.

Limitations

  • Relies heavily on historical data for beta, which may not predict future risk accurately.

  • Assumes markets are perfectly efficient, which may not always hold true.

  • Does not account for other risk factors like liquidity risk, inflation, or behavioral influences.

Why It Matters?

CAPM remains a cornerstone in modern portfolio theory and investment decision-making. For wealth managers, it serves as a useful tool to evaluate risk-return trade-offs, set realistic client expectations, and make informed portfolio construction decisions.