Capital Asset Pricing Model (CAPM)
Candlefocus EditorThe CAPM formula is commonly expressed as:
Expected return= Risk-free return + Beta × (Expected return of the market - Risk-free return)
The formula indicates that the expected return of an individual asset will equal the risk-free return, such as that of a Treasury bill, plus a risk premium that reflects the asset's non-diversifiable risk. Beta is the statistical measure of an asset's non-diversifiable risk, measuring the asset's volatility relative to the market. A beta of 1.0 indicates that the asset has the same volatility as the market. A beta value greater than 1 indicates that the asset is more volatile than the market, and a beta value less than1 indicates that the asset is less volatile than the market.
The CAPM formula can be used to compare investments. For instance, if an investor is considering two investments with different betas, the investment with the higher beta will have a higher expected return according to the CAPM. Additionally, CAPM is used to analyze and compare portfolios with different weights in asset classes.
Despite its popularity, there are some criticisms and limitations to the CAPM. First, CAPM relies on the assumptions of perfect information, investor homogeneity, and constant risk and return. These assumptions may not be realistic, as some assets exhibit non-linear risk vs. return profiles. Additionally, CAPM relies on a linear interpretation of risk and return, which may neglect other aspects of an asset's risk profile.
Nonetheless, the CAPM is still regarded as an important tool to evaluate asset returns. Investors use CAPM to evaluate and compare investments and portfolios, and it is an integral part of modern portfolio theory. CAPM's reliance on an easy-to-calculate single-factor formula makes it attractive to portfolio manager who need to quickly make decisions. Additionally, the CAPM formula is simple and straightforward, making it easy to understand and apply.