Capital Asset Pricing Model: Introduction

The capital asset pricing model, or CAPM, is a financial model that calculates the expected rate of return for an investment.

CAPM calculates the expected return from the investment based on factors such as a risk-free rate, the beta factor for the underlying transaction, and the current market risk premium.

The risk-free rate is typically the yield of government bonds, while the risk premium is determined by the asset's beta, which measures the asset's return sensitivity to market movements.

Consider the common stock of Company A with a beta of point five. If the risk-free rate is three percent and the market risk premium is five percent, the expected return for the common stock of Company A would be five point five percent.

This means that the expected annual return on an investment in the common stock of Company A is five point five percent based on the present risk and market conditions.

The CAPM formula is still widely used because it is simple and allows for easy comparisons of investment alternatives.

It helps investors determine the expected return on an investment based on its risk relative to the market.