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Capital Asset Pricing Model CAPM
Definition
The Capital Asset Pricing Model (CAPM) determines an investor's required rate of return for a risky asset (an asset with greater risk than a treasury security). The model requires certain inputs such as the current risk free rate of return (in the U.S. this is treasuries), beta (whch measures the sensitivity of the asset to the return available in the market, and the expected return of the broad market.
Using the term Capital Asset Pricing Model CAPM :
Essentially, the CAPM is calculated as follows: Expected Return of a Risky Asset = Rf + B(Rm - Rf) Where: Rf = Current Treasury Rates B = Beta of the Asset Rm = Expected Return of the market
Pay Special Attention To :
The CAPM is an academic theory. It is very useful and supplies a uniform theory of estimating returns; however, it also has certain limitations as an academic theory. Be mindful of these limitations and always look at the output of equations with a critical eye to ensure they pass a reality check with what you belive seems accurate. If the estimate is widely different than your reasonable expectation, then there is something likely amiss. Some requirements, and hence, limitations of the CAPM are that is assumes the following about all investors: -- All investors act rationally and are risk-averse. -- All investors can lend and borrow unlimited amounts at the risk free rate. -- There are not taxes or transaction costs. -- The market is efficient and all investors have access to the same information at the same time. Hence, despite its excellent approximations, you can detect some of CAPM's limitations.
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Related terms
quantitative analysis
