The Capital Asset Pricing Model (CAPM) is a fundamental financial model used to determine the expected return on an investment, considering its risk relative to the overall market. CAPM establishes a linear relationship between the expected return of an asset and its systematic risk, measured by beta.
Key Elements of CAPM
• Expected Return (ER): The return an investor should anticipate from an investment given its risk.
• Risk-Free Rate (Rf): The return on a theoretically riskless investment, typically government securities like Treasury bills.
• Beta (β): A measure of an asset’s sensitivity or volatility relative to the overall market. A beta of 1 means the asset moves in line with the market, above 1 indicates higher risk and volatility, and less than 1 means lower volatility.
• Market Risk Premium (ERm − Rf): The additional return expected from investing in the market portfolio over the risk-free investment.
CAPM Formula
Expected Return (ERi) = Rf + βi × (ERm − Rf)
Where:
• ERi = expected return on investment i
• Rf = risk-free rate
• βi = beta of investment i
• ERm = expected return of the market portfolio
• ERm − Rf = market risk premium
Interpretation
CAPM indicates investors require compensation for two components: the time value of money (risk-free rate) and the risk undertaken above a risk-free investment (risk premium adjusted by beta). This helps in setting the “hurdle rate” or required rate of return for investments and projects.
Applications
• Cost of Equity: CAPM is widely used to calculate the cost of equity, an essential input in valuation models and capital budgeting.
• Portfolio Management: It helps assess whether an asset or portfolio is fairly priced relative to its risk.
• Risk Assessment: Beta helps identify how much systematic market risk an asset contributes.
Assumptions and Limitations
• Assumes markets are efficient and investors are rational and risk-averse.
• Assumes a single-period investment horizon and no taxes or transaction costs.
• Beta reflects only systematic risk; unsystematic risks are diversifiable and thus not rewarded.
• Real-world factors sometimes limit the accuracy of CAPM predictions.
Summary
In summary, CAPM provides a structured and widely accepted approach to link risk and expected return in financial decisions, especially useful in pricing securities, managing portfolios, and making capital investment choices within banking and finance.
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