Capital Asset Pricing Model (CAPM)
A model relating expected return to systematic risk (beta). Foundation for understanding alpha and beta.
What it means
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk (beta) and expected return. It states that the expected return of an investment equals the risk-free rate plus a risk premium proportional to its beta.
The math
The risk-free rate is the baseline return for no risk. Beta determines how much of the market risk premium (excess market return) you're exposed to.
How to read it
- Core InsightHigher beta → higher expected return, but also higher risk
- Risk PremiumThe (Market Return - Risk-Free Rate) portion compensates for market risk
Worked example
If risk-free rate = 3%, expected market return = 10%, and your portfolio beta = 1.2, expected return = 3% + 1.2 × (10% - 3%) = 11.4%.
In context
CAPM provides the theoretical foundation for understanding alpha and beta. It helps determine whether an investment is fairly priced for its risk level and is used extensively in corporate finance for cost of equity calculations.
Common mistakes to avoid
- Taking CAPM as literal truth (it's a simplified model)
- Ignoring that real markets have many anomalies CAPM doesn't explain
- Using historical beta as a perfect predictor of future beta
Keep exploring
Beta
Measures how much a portfolio moves relative to the market. Beta of 1 means it moves with the market.
Alpha
The excess return of a portfolio compared to what would be expected given its beta. Positive alpha means outperformance.
Modern Portfolio Theory (MPT)
Framework for constructing portfolios that maximize expected return for a given level of risk through diversification.
Efficient Frontier
The set of portfolios offering the highest expected return for each level of risk. Optimal portfolios lie on this curve.
Correlation
Measures how two assets move together. Ranges from -1 (opposite) to +1 (identical). Key for diversification.
Articles
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