The Capital Asset Pricing Model (CAPM) is a widely-used financial model that helps investors determine the expected return on an asset based on its level of risk. The basic equation for the CAPM is as follows:
r_i = r_f + β_i (r_m – r_f)
- r_i is the expected return on asset i
- r_f is the risk-free rate of return
- β_i is the asset’s beta, which measures its volatility in relation to the market as a whole
- r_m is the expected return on the market as a whole
The equation states that the expected return on an asset is equal to the risk-free rate plus a premium based on the asset’s beta and the expected return of the market. The premium is calculated as the difference between the expected return on the market and the risk-free rate, multiplied by the asset’s beta.
The CAPM is based on several assumptions, including that investors are rational and risk-averse, and that markets are efficient and information is freely available. It is often used to calculate the cost of equity for a company, which is the return that investors expect to receive for holding the company’s stock.
While the CAPM has its limitations and critics, it remains a widely-used model for estimating the expected return on an asset, and is an important tool for investment professionals.
What is the Capital Asset Pricing Model (CAPM)?
What is the equation for the CAPM?
How is beta calculated in the CAPM?
What are the assumptions of the CAPM?