CAPM
Capital Asset Pricing Model — a model describing the relationship between systematic risk and expected return, used to price risky securities and calculate cost of equity.
Example
“CAPM showed the stock's expected return was 11% — risk-free rate plus beta times the equity risk premium.”
Memory Tip
CAPM = Expected Return = Risk-Free Rate + Beta × Market Risk Premium.
Why It Matters
CAPM helps you understand whether an investment is worth the risk you are taking on. It provides a framework for determining if the expected return of a stock or investment adequately compensates you for the risk involved, which is essential for building a balanced portfolio that matches your financial goals.
Common Misconception
Many people think CAPM predicts future stock prices or guarantees returns, but it actually only estimates what return you should expect based on risk levels. The model uses historical data and assumptions that may not hold true in real market conditions, so actual returns can differ significantly from CAPM predictions.
In Practice
Suppose a stock has a beta of 1.5 (50 percent more volatile than the market), the risk-free rate is 2 percent, and the market return is 10 percent. CAPM would calculate the required return as 2% + 1.5(10% - 2%) = 14%, meaning you should expect at least a 14% annual return to justify owning that higher-risk stock compared to safer investments.
Etymology
Acronym for Capital Asset Pricing Model. A MODEL for PRICING CAPITAL ASSETS based on risk.
Common Misspellings
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