## What is CAPM (Capital Asset Pricing Model)?

The Capital Asset Pricing Model (CAPM) is a financial model used to determine the expected return on an investment based on its risk. It helps investors understand how much return they should expect from an investment given its level of risk. CAPM considers the risk-free rate, the expected market return, and the asset's beta to calculate the appropriate expected return. By using CAPM, investors can make informed decisions about the potential rewards and risks of different investments.

#### Key takeaways

- The Capital Asset Pricing Model (CAPM) estimates the expected return on an investment based on its risk.

- It considers the risk-free rate, the expected market return, and the asset's beta.

- CAPM helps investors make informed decisions about the potential rewards and risks of investments.

## Understanding CAPM (Capital Asset Pricing Model)

Imagine you're considering investing in a stock or a portfolio of stocks, and you want to evaluate its expected return based on its risk. The Capital Asset Pricing Model (CAPM) is a financial model that helps you estimate the appropriate return based on the riskiness of the investment.

To use CAPM, you need three key inputs: the risk-free rate, the expected market return, and the asset's beta. The risk-free rate is the return you can earn on a risk-free investment, such as government bonds. The expected market return represents the average return expected from the overall market. And the asset's beta measures its sensitivity to market movements.

## How does CAPM (Capital Asset Pricing Model) work?

CAPM uses these inputs to calculate the expected return of an investment. The formula is as follows:

Expected Return = Risk-Free Rate + Beta × (Expected Market Return - Risk-Free Rate)

Let's break it down with an example. Suppose the risk-free rate is 3%, the expected market return is 8%, and the stock you're evaluating has a beta of 1.2.

Expected Return = 3% + 1.2 × (8% - 3%) = 3% + 1.2 × 5% = 9%

In this example, CAPM estimates that the stock should provide an expected return of 9% based on its risk profile.

## Real world example of CAPM (Capital Asset Pricing Model)

Let's say you're considering investing in two stocks: Stock A and Stock B. Stock A has a beta of 1.5, while Stock B has a beta of 0.8. The risk-free rate is 2%, and the expected market return is 7%.

Using CAPM, you can calculate the expected return for each stock:

Expected Return of Stock A = 2% + 1.5 × (7% - 2%) = 2% + 1.5 × 5% = 9.5%

Expected Return of Stock B = 2% + 0.8 × (7% - 2%) = 2% + 0.8 × 5% = 6%

Based on CAPM, Stock A is expected to provide a higher return of 9.5% due to its higher beta, indicating greater sensitivity to market movements. Stock B, with a lower beta, is expected to provide a lower return of 6%.

## The bottom line

The Capital Asset Pricing Model (CAPM) is a financial model that estimates the expected return on an investment based on its risk. By considering the risk-free rate, the expected market return, and the asset's beta, CAPM helps investors evaluate the potential rewards and risks of different investments.

It provides a framework for making informed investment decisions by aligning expected returns with the level of risk associated with an investment. Understanding CAPM allows investors to assess the appropriate return they should expect from investments.