Capital Asset Pricing Model (CAPM)

Definition

The Capital Asset Pricing Model (CAPM) is a financial model that establishes a relationship between the expected return of an asset and its systematic risk, represented by beta. It helps investors assess the return they should expect for taking on additional risk compared to a risk-free investment. The model serves as a cornerstone in various finance areas, including understanding diversification, portfolio risk, stock valuation, and calculating the cost of capital.

5 Must Know Facts For Your Next Test

1. CAPM is used to estimate the expected return on an asset by using the formula: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate).
2. The model assumes that investors hold diversified portfolios to eliminate unsystematic risk, focusing instead on systematic risk measured by beta.
3. CAPM plays a crucial role in stock valuation models by providing a way to estimate required returns based on perceived risk.
4. The cost of equity calculated through CAPM is essential for firms when determining their overall cost of capital.
5. Incorporating CAPM into hedging and risk management strategies helps investors make informed decisions about which assets align with their risk tolerance.

Review Questions

• How does CAPM inform investors about the relationship between risk and expected return when constructing diversified portfolios?
  • CAPM emphasizes that in a well-diversified portfolio, unsystematic risk can be eliminated, leaving only systematic risk. This means that the expected return on an asset must reflect its beta, which measures its sensitivity to market movements. Thus, investors can use CAPM to gauge whether an asset offers an adequate return for its level of risk relative to the overall market.
• In what ways does CAPM influence stock valuation and the assessment of potential investments?
  • CAPM influences stock valuation by providing a systematic approach to determine the expected return required by investors based on an asset's risk profile. By integrating beta into the valuation models, investors can ascertain if a stock is undervalued or overvalued compared to its expected return. This allows for more informed investment decisions and helps in pricing stocks according to their inherent risks.
• Evaluate how understanding CAPM can enhance decision-making in managing a firm's overall cost of capital and investment strategies.
  • Understanding CAPM enables firms to accurately estimate their cost of equity, which is essential when calculating their overall cost of capital. This insight guides firms in making strategic decisions about financing projects, assessing whether potential investments meet their return requirements. By applying CAPM, businesses can align their investment strategies with market expectations and effectively manage their financial risks.

Related terms

Beta:

A measure of a stock's volatility in relation to the overall market; it indicates how much the asset's price moves compared to market movements.

Risk-Free Rate: The return on an investment with zero risk, typically represented by government treasury bonds, used as a baseline for evaluating investment performance.

Market Portfolio: A theoretical portfolio that contains all available assets in the market, weighted according to their market value; it is used as a benchmark in CAPM calculations.