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CAPM (Capital Asset Pricing Model)

According to Modern Portfolio Theory it is possible to eliminate the unsystematic or, as it is also called, the “specific risk” through diversification. However, no matter how diversified the investments are, the problem of systematic risk still remains unsolved. This is what excites most investors while calculating the expected return.

In 1964 William Sharpe and John Lintner created the Capital Asset Pricing Model (CAPM), a specific way of measuring the market or systematic risk. In 1990 Sharpe won a Nobel Prize for developing such a model and up till now the CAPM is popular and is extensively used among investors for calculating investment risk and estimating what returns to expect.

Sharpe’s model is based on Modern Portfolio Theory by Harry Markowitz and it turns the theory’s algebraic statement into a testable prediction about the relation between risk and expected return. Therefore, in general, the CAPM shows the relationship between the risk of a particular security and the investor’s expected return.

CAPM Formula

So to understand what CAPM means for an average investor, it is important to look at its formula.

  • (Rf) Risk free rate is the return an investor expects from an absolutely risk-free investment in a particular time frame. This is the minimum return an investor can expect.
  • (Rm) The expected market return is the return an investor expects from a broad stock market indicator like the S&P 500 Index.
  • (β) Beta is the measure of a portfolio or an individual security volatility versus the entire market. So, it is used to calculate the risk of a security. The calculation is done by regression analysis: if beta is higher than 1, this shows that the security will be more volatile than the market. If beta equals to 1, than the security price will move with the market. And if beta is less than 1, it means that the security will be less volatile than the market.

CAPM Formula Example

Let’s assume that the risk-free rate is 2%, the risk measure or beta is 5 and the expected market return a particular period of time is 10%. The expected return in this example will be 42% as calculated by the CAPM formula: (2%+5(10%-2%)).

CAPM serves traders and investors as a tool to estimate what return to expect from their investments and helps them combine low risk investments with riskier alternatives to form a portfolio best suited to investors' preferences.