# What Does Capital Asset Pricing Model - CAPM Mean?

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

Investopedia explains Capital Asset Pricing Model - CAPM The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

Capital Asset Pricing Model
Bill Sharpe made his first big breakthrough by taking the picture on the previous page and showing how the market must price individual securities in relation to their asset class (a.k.a. the index, or the "optimal mix" in the picture). The derivation isn't exactly a walk in the park (yikes!), but the result is a simple linear relationship known as the Capital Asset Pricing Model: r = Rf + beta x ( Km - Rf ) where r is the expected return rate on a security; Rf is the rate of a "risk-free" investment, i.e. cash; Km is the return rate of the appropriate asset class. Beta measures the volatility of the security, relative to the asset class. The equation is saying that investors require higher levels of expected returns to compensate them for higher expected risk. You can

and instead build portfolios out of low cost index funds. There are also ongoing attempts at "building better betas" that incorporate company debt and other traditional valuation measures. because you only have to calculate the covariances of every pair of classes. If you are trying to duplicate an expected return that's greater than that of the asset class. (One point about that last paragraph. because you can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class. instead of every pair of everything. or whether you need to divide much further (into "domestic mid-cap value stocks". For one thing it turns finding the efficient frontier into a doable task. Another consequence is that CAPM implies that investing in individual stocks is pointless. you have to hold "negative" cash. With CAPM you assume that there are no transactional costs or taxation and assets and securities are divisible into small little packets. It also assumes that investors are "price takers" who can't influence the price of assets or markets. All of this is a full-time job for academic modern portfolio theorists (and deriding the whole effort is a popular hobby for some traditional stock analysts: how could a magnificent company equal a mediocre one times beta? To them. and so on). and those who do take risks. CAPM .) CAPM has a lot of important consequences. expect to be rewarded. This is consistent with the big message of MPT . meaning you have to buy the index on margin.The Capital Asset Pricing Model "Cap-M" looks at risk and rates of return and compares them to the overall stock market. (risk averse). to measure risk.that trying to beat the index is inherently risky). Naturally. Had enough with the assumptions yet? One more. If you use CAPM you have to assume that most investors want to avoid risk.think of the formula as predicting a security's behavior as a function of beta: CAPM says that if you know a security's beta then you know the value of r that investors expect it to have. This is why followers of MPT avoid stocks. Part of the question is how few classes you can get away with: whether you can use a very coarse division into just "stocks" and "bonds". CAPM seems like a very blunt instrument. instead of relying solely on past volatility. CAPM assumes that investors are not limited in their borrowing and lending under the risk free . somebody has to verify that this simple relationship actually holds true in the market.

Ks = Krf + B ( Km . We'll deal with that below.) . You can find a company's beta at the Yahoo!! Stock quote page. but first. you gotta know about Beta. (or just the rate of return). If the company has a beta of 3. Beta. A company's beta is that company's risk compared to the risk of the overall market. Each company also has a beta.0000.rate of interest. By now you likely have a healthy feeling of skepticism. (You have to guess what rate of return you think the overall stock market will produce. then it is said to be 3 times more risky than the overall market. like U. Beta is the overall risk in investing in a large market.Krf) y y y y Ks = The Required Rate of Return. 1 exactly.Now.Read our Disclaimer) B = Beta (see above) Km = The expected return on the overall stock market. Government Treasury Bonds .0.S. like the New York Stock Exchange. Krf = The Risk Free Rate (the rate of return on a "risk free investment". Beta . let's work the CAPM formula. by definition equals 1.