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What is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) provides a framework for estimating the expected return of an investment based on its systematic risk. The model was developed by William Sharpe, John Lintner, and Jan Mossin in the 1960s and has since become a fundamental tool in finance and investment analysis.
Key components of the Capital Asset Pricing Model include:
Expected Return: The CAPM is concerned with the expected return of an investment, which represents the compensation an investor demands for taking on the investment's risk.
Systematic Risk: The CAPM focuses on systematic risk, which is the risk that cannot be eliminated through diversification. It is measured by the beta (β) of an investment, which reflects its sensitivity to overall market movements.
Risk-Free Rate: The model assumes the existence of a risk-free asset, such as a government bond, that offers a known return with no risk. The risk-free rate is typically represented by the yield on this asset.
Market Risk Premium: The CAPM incorporates the market risk premium, which represents the excess return that investors expect to receive for holding a risky asset compared to a risk-free asset. It is determined by the overall level of market risk and the risk aversion of investors.
CAPM Formula: The expected return of an investment according to the CAPM can be calculated using the following formula:
Expected Return = Risk-Free Rate + β * (Market Risk Premium)
This formula indicates that an investment's expected return is equal to the risk-free rate plus a risk premium determined by the investment's beta and the market risk premium.
Efficient Frontier: The CAPM implies that in an efficient market, where all investors have access to the same information and hold diversified portfolios, the optimal portfolio lies on the efficient frontier. The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk.
The CAPM has practical applications in various areas, including investment valuation, portfolio management, and determining the required rate of return for capital budgeting decisions. However, it does rely on several simplifying assumptions, such as perfect markets, linear relationships, and homogenous expectations, which may limit its accuracy in real-world situations. The CAPM has also faced criticism and challenges, with alternative models and factors emerging to account for additional sources of risk and market anomalies.
CAPM is covered in more detail in module 2 of the CQF program.