Capital Asset Pricing Model (CAPM)

The CAPM helps us understand the relationship between the risk of an asset and its expected return. It's widely used to estimate how much return an investor should expect for taking on additional risk.

Calculate Expected Return Using CAPM

Visualization

Risk-Free Rate: This is the return you'd expect from an investment with no risk, like government bonds.
Beta: This measures how much the stock's price moves relative to the market. A higher beta means more volatility and potential for higher returns.
Market Return: The average return of the market, which we use as a benchmark.
Expected Return: This is the return we calculate using the CAPM formula, considering the risk-free rate, beta, and market return.

Real-World Applications of CAPM

The CAPM is used in various ways in finance:

To estimate the cost of equity capital for companies.
For portfolio management and optimization.
To value stocks and other financial assets.
To assess the performance of mutual funds and other investment portfolios.

Assumptions and Limitations of CAPM

CAPM is based on several assumptions:

Investors are rational and prefer less risk.
Markets are efficient, and all investors have access to the same information.
There are no taxes or transaction costs.
Investors can lend and borrow at the risk-free rate.

However, it has some limitations:

Real markets aren't perfectly efficient.
Investor behavior can be irrational.
Taxes and transaction costs exist.
Risk-free borrowing and lending aren't always possible.

Case Studies

Let's look at some real-world examples of CAPM in action:

Company Valuation: Analysts use CAPM to estimate the cost of equity for companies like Apple and Microsoft.
Portfolio Management: CAPM is used in constructing and optimizing investment portfolios.