Capital Asset Pricing Model (CAPM)

Overview of Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a fundamental tool we use to determine the expected return on an investment and assess its risk relative to the market.

CAPM importantly introduces the concept of beta, a measure of a stock’s volatility in relation to the overall market volatility. It tells us how much risk we’re taking on with a particular investment.

In CAPM, we categorize the risk into two parts: systematic and idiosyncratic risk. Systematic risk is the inherent risk we can’t avoid, linked to broader economic factors.

On the other hand, idiosyncratic risk is unique to a specific company or industry and can be diversified away. CAPM focuses primarily on the systematic risk and its compensation through returns.

Our formula for CAPM is:
Expected Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)

Here’s a quick breakdown of each term in the CAPM equation:

Term	Meaning
Risk-Free Rate	The return on an investment with zero risk, such as government bonds.
Beta	The volatility measure of a security versus the market.
Market Return	The expected return of the market over a period of time.
Expected Return	The return we would anticipate from an investment given its risk.

By using CAPM, we can find the proper balance in our investment portfolio, weighing expected returns against the associated risks. This helps us in our goal to maximize returns while keeping the risk at a level that we’re comfortable with.