CAPM the Capital Asset Pricing Model (CAPM)

CAPM

The capital asset pricing model (CAPM)

The basic concept behind the capital asset pricing model (CAPM) is that when investors accept additional risk, they should be rewarded with greater compensation. The formula for the model is as follows:

(Image source: CAPM, 2013, Investopedia)

It should be noted that the CAPM is just that -- a model -- and certain artificial conditions are assumed to make the formula work, namely an absence of taxes and transaction costs like broker's fees; symmetrical knowledge of information and "identical investment horizons" for all investors; and finally that "all investors have identical opinions about expected returns, volatilities and correlations of available investments" (Capital asset pricing model, 2013, Risk Encyclopedia). In the model, "the time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf)" (CAPM, 2013, Investopedia).

In the CAPM, two fundamental types of risk exist: risk that is systemic to the market and risks which are specific. Systemic risk is the risk of holding the 'baseline' market portfolio. As the market goes up or down, the entire portfolio responds and thus is subject to systemic environmental risk while specific risk is specific to a particular asset (Capital asset pricing model, 2013, Risk Encyclopedia). It is assumed that the risk of specific assets can be 'hedged' with diversification while "systematic risk can be measured using beta. According to the capital asset pricing model, the expected return of a stock equals the risk-free rate plus the portfolio's beta multiplied by the expected excess return of the market portfolio….Stated another way, the stock's excess expected return over the risk-free rate equals its beta times the market's expected excess return over the risk free rate" (Capital asset pricing model, 2013, Risk Encyclopedia).