Capital Asset Pricing Model (CAPM)
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.
1
U.S. Department of Commerce, Commercial Law Development Program. “Financial Modeling: CAPM &
WACC.”
It is a finance model that establishes a linear relationship between the required return on an investment
and risk. The model 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.
The capital asset pricing model – or CAPM – is a financial model that calculates the expected rate of return
for an asset or investment.
CAPM does this by using the expected return on both the market and a risk-free asset, and the asset’s
correlation or sensitivity to the market (beta).
There are some limitations to the CAPM, such as making unrealistic assumptions and relying on a linear
interpretation of risk vs. return.
Despite its issues, the CAPM formula is still widely used because it is simple and allows for easy
comparisons of investment alternatives.
For instance, it is used in conjunction with modern portfolio theory (MPT) to understand portfolio risk and
expected return.
The formula for calculating the expected return of an asset, given its risk, is as follows:
ERi=Rf+βi(ERm−Rf)
where:
ERi=expected return of investment
Rf=risk-free rate
βi=beta of the investment
(ERm−Rf)=market risk premium