Definition
Capital Asset Pricing Model (CAPM) is a financial model used to determine the theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. It balances the asset’s risk against the risk of the market to determine its worth.
Etymology
The term rolls out from the red carpets of financial theory, where “capital” refers to wealth in the form of money or other assets owned by a person or organization. “Asset” stands for resources with economic value, and “pricing”, well, pertains to the tag attached. Finally, “model” is not walking the runway here; it refers to our theoretical framework. Put them together, and you get a high-class finance formula that’s the life of the party in risk and return discussions.
Application of CAPM
The CAPM formula says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. This supposes that investors need to be compensated in two ways: time value of money and risk. Essentially, it tells you to demand more candies (returns) if you’re venturing into a haunted house (higher risk investment).
Formula
The formula itself kicks off the party with:
\[ E(R_i) = R_f + \beta_i (E(R_m) - R_f) \]
Where:
- \( E(R_i) \) is the expected return on the capital asset
- \( R_f \) is the risk-free rate
- \( \beta_i \) is the beta of the asset
- \( E(R_m) \) is the expected return of the market
Practical Examples
Let’s play matchmaker. Imagine you’re evaluating a glamorous stock with a beta of 1.5. If the risk-free rate is 2% and the market is expected to return 10%, CAPM says the stock should strut a return of 14%. It’s about balancing the tiara on the head, not just wearing it.
Related Terms
- Beta: A measure of an asset’s volatility relative to the market.
- Risk-Free Rate: The return on an investment with zero risk, often represented by Treasuries.
- Market Return: The average return of the financial markets; often used as a benchmark to compare other investments.
Further Reading
To trim the edges of your financial knowledge about CAPM, consider diving into these literary treasures:
- “Investments” by Zvi Bodie, Alex Kane, and Alan J. Marcus, for an in-depth discussion on various investment tools including CAPM.
- “The Theory of Investment Value” by John Burr Williams, a classic that explores foundational concepts relevant to CAPM.
CAPM is not just a model; it’s a lens to view the risks dancing around us. So next time, before lacing up your investment shoes, make sure to measure your financial runway with CAPM, and walk it like you own it!
