What is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) is a formula that connects investment risk to expected return. It shows how much extra return investors should demand for taking on systematic risk—the risk that affects all investments and cannot be diversified away.
CAPM calculates expected return as E(R) = Rf + β(Rm − Rf), where Rf is the risk-free rate, β is systematic risk, and (Rm − Rf) is the market risk premium.
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Step-by-step worked examples
A stock with β=1.1, risk-free rate 2%, expected market return 8%. Find expected return.
E(R) = Rf + β(Rm − Rf) E(R) = 2 + 1.1(8 − 2) E(R) = 2 + 6.6 = 8.6%
β=1.5, Rf=3%, Rm=10%. Calculate E(R).
E(R) = 3 + 1.5(10 − 3) E(R) = 3 + 10.5 = 13.5%
Conservative bond fund: β=0.8, Rf=2.5%, Rm=9%. Expected return?
E(R) = 2.5 + 0.8(9 − 2.5) E(R) = 2.5 + 5.2 = 7.7%
Flashcards
Quick quiz
Q1.CAPM formula is…
Q2.What does β=2 mean?
Q3.Higher beta → higher…
Q4.Risk-free rate (Rf) is typically…
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Common mistakes
Confusing beta with total volatility. — Correct: Beta measures only systematic risk, not total variance.
Thinking β<1 means negative expected return. — Correct: β<1 means less risky than market, but still positive return if Rm > Rf.
Ignoring the market risk premium (Rm − Rf). — Correct: The premium is the extra return for accepting market risk.
Assuming CAPM works for all investments equally. — Correct: CAPM assumes market efficiency and rational investors; real markets deviate.
FAQ
What is the CAPM formula?
E(R) = Rf + β(Rm − Rf). It combines the risk-free rate with a risk-adjusted premium.
What is beta in CAPM?
Beta is systematic risk; β=1 is market average, β>1 is riskier, β<1 is safer.
What is the risk-free rate?
Return on zero-risk assets, typically 2–3% from government bonds.
Why use CAPM?
To determine the fair expected return required for an investment's risk level.