Introduction to CAPM

Understanding the Relationship between Risk and

Return
Overview of CAPM

Definition: CAPM is a financial model used to determine the expected return on an investment based
on its systematic risk.

Key Components: Risk-free rate, Market risk premium, Beta coefficient

Objective: To estimate the required return for an asset given its risk profile.
Assumptions of CAPM

Efficient Markets: Markets are efficient, and asset prices reflect all available information.

Homogeneous Expectations: Investors have identical expectations about future returns, risk, and
correlations.

Perfect Capital Markets: No transaction costs, taxes, or restrictions on borrowing/lending.

Other Assumptions: Unlimited short selling, single investment period, normal distribution of returns
Calculation of Expected Return

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

Explanation: The expected return on an asset is the sum of the risk-free rate and the product of its beta
coefficient and the market risk premium.

Example: Illustrative calculation of expected return using hypothetical values.

Beta Coefficient

Definition: Beta measures an asset's sensitivity to market movements.

Interpretation: Beta of 1 implies the asset moves in line with the market. Beta > 1 indicates higher
volatility, and Beta < 1 indicates lower volatility.

Importance: Beta helps investors assess an asset's risk relative to the market.
Applications and Limitations

Applications: Pricing financial assets, Portfolio management, Asset allocation decisions.

Limitations: Relies on several simplifying assumptions that may not hold in real-world markets.
Empirical challenges in its application.

Conclusion: Despite limitations, CAPM remains a valuable tool for understanding risk-return
relationships and asset pricing.