What Is the Capital-Asset-Pricing Model?
The capital asset pricing model, or CAPM, is a way of looking at the risk and return of an investment. It is a ratio that evaluates the risk of the investment against both "risk-free" U.S. Treasury bills and the stock market as a whole. There is no single preferred CAPM. Each investor can choose his desired CAPM based upon how much risk he is comfortable taking on.
* Calculating CAPM relies on knowing the risk-free return rate, which is the current Treasury bill or T-bill rate, and the historical return rate of the stock market over a given period. This rate is known as the "beta" of an investment. A beta of 1 indicates the investment performs exactly the way the stock market does. A stock with a beta of -1 moves exactly opposite to the market; the investment's value goes down when the market goes up and goes up when the market goes down. A stock with a beta of 0.5 would move half as much as the market, but in the same direction as the market.
* In CAPM, the Risk of the Asset r(A) equals the Risk Free Rate r(F) plus the Beta of the Asset B(A) times the Market Return r(M), less the Risk Free rate r(F). For example, say the beta of your new investment is 0.5, the T-bill return is 3 percent and the market return is 12 percent. The calculation is:
r(A) = r(F) + B(A) (r(M) - r(F)), or r(A) = 3 + 0.5 (12 - 3).
Since r(A) = 7.5, the expected return of the new asset is 7.5 percent.
* The CAPM model implies that all assets are being evaluated over the same period of time -- for instance, that the 3 percent T-bill rate and 12 percent market rate are both based on one year's return. It also assumes that every investor has at least some money in a risk-free asset, but that the portfolio is fully diversified. And of course, the beta of the asset must be known; that is, it can't be a brand-new investment with no historical data available data.
* A more...