CAPITAL ASSET PRICING MODEL (CAPM)

Summary

The Capital Asset Pricing Model (CAPM) is a fundamental financial formula that helps investors determine what return they should expect from an investment based on its risk level. It calculates expected return using three key components: the risk-free rate (return from safe investments like government bonds), beta (how much the investment moves compared to the overall market), and the market risk premium (extra return expected from investing in the risky stock market versus safe investments). The formula is: Expected Return = Risk-free Rate + Beta × (Market Return - Risk-free Rate).

Usage Context

CAPM is crucial when studying portfolio management, cost of capital calculations, investment valuation, and risk assessment. It's fundamental for understanding how risk and return are related in financial markets and forms the basis for many other financial models and investment strategies.

Common Confusions

• Confusing beta with volatility - beta measures correlation with market movement, not just price swings
• Thinking CAPM predicts actual returns rather than expected returns
• Assuming CAPM works for all types of investments when it's primarily for publicly traded stocks
• Misunderstanding that higher beta always means higher expected return without considering the risk-return tradeoff
• Confusing the market risk premium with the total market return