Capital Asset Pricing Model (CAPM)

Discipline: Economics

Capital asset pricing model (CAPM) is a model of financial economics that is used to measure the rate of return of an asset in a well-diversified portfolio, and thus determining its value. Capital asset pricing model (CAPM) is therefore a model used to determine the price of an asset.

Capital asset pricing model (CAPM) was introduced by JACK TREYNOR, WILLIAM SHARPE, JOHN LINTNER and JAN MOSSIN, who built on the work of HARRY MARKOWITZ.

Under the capital asset pricing model (CAPM), the price of an asset is determined in accordance to its reward-to-risk ratio, where the reward is the expected rate of return in the market, and the risk is the asset's non-diversifiable risk (β), also referred to as systematic risk, or market risk. The β (beta) here is the measure of the risks involved in a particular stock or portfolio in relation to the overall market risk.

The β (beta) of the stock or portfolio in question therefore equals to:

Reward-to-risk ratio of the stock/portfolio / Reward-to-risk ratio of the market

Derived from this formula, the capital asset pricing model (CAPM) is expressed as:

E(Ri) = Rf + βim(E(Rm) - Rf); where:

E(Ri is the expected rate of return on the capital asset,

Rf is the risk-free rate of interest, as in the T-Bills,

βim is the beta coefficient,

E(Rm) is the expected return in the market, and

E(Rm) - Rf is the difference between the expected market rate of return and the risk-free rate of return, or market premium, or risk premium.

Also see: arbitrage pricing policy, beta coefficient (β), capital, capital asset, marginal efficiency of capital, portfolio selection theory, uncertainty

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