Capital Asset Pricing Model

Key Highlights

• CAPM is a widely used financial framework that explains the relationship between expected return and risk of an investment.

• Expected Return (Re) = Risk-Free Rate (Rf) + Beta (β) × [Market Return (Rm) – Risk-Free Rate (Rf)]

What is Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a widely used financial framework that explains the relationship between expected return and risk of an investment. It provides a formula to calculate the expected return on a security by considering the risk-free rate, the security’s sensitivity to market movements (beta), and the expected market return.

CAPM Formula

Expected Return (Re) = Risk-Free Rate (Rf) + Beta (β) × [Market Return (Rm) – Risk-Free Rate (Rf)]

Where:

• Risk-Free Rate (Rf): Return on a risk-free asset, such as government securities.

• Beta (β): A measure of a security’s volatility relative to the overall market.

• Market Return (Rm): Expected return from the market portfolio.

Key Assumptions of CAPM

• Investors are rational and risk-averse.

• Markets are efficient, and all investors have equal access to information.

• There are no transaction costs or taxes.

• Returns are normally distributed over time.

Limitations

• Relies heavily on historical data for beta, which may not predict future risk accurately.

• Assumes markets are perfectly efficient, which may not always hold true.

• Does not account for other risk factors like liquidity risk, inflation, or behavioral influences.

Why It Matters?

CAPM remains a cornerstone in modern portfolio theory and investment decision-making. For wealth managers, it serves as a useful tool to evaluate risk-return trade-offs, set realistic client expectations, and make informed portfolio construction decisions.