Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between systematic risk and expected return for assets, particularly stocks. It is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given its level of risk.
History and Development
CAPM was developed in the early 1960s by several economists, with key contributions from:
The model was initially part of the portfolio theory developed by Harry Markowitz, who laid the foundation for understanding how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk.
Core Concepts of CAPM
CAPM is based on the following assumptions:
- Investors are rational, risk-averse, and aim to maximize economic utility.
- Investors have identical expectations regarding returns, variances, and covariances of all assets.
- There are no taxes or transaction costs.
- Information is freely and simultaneously available to all investors.
- All investors can borrow and lend at a risk-free rate.
The CAPM formula is expressed as:
E(Ri) = Rf + βi * (E(Rm) - Rf)
- E(Ri) - Expected return on the capital asset.
- Rf - Risk-free rate.
- βi - Beta of the investment, measuring the sensitivity of the asset's returns to market returns.
- E(Rm) - Expected return of the market.
Application and Critiques
CAPM has been widely used in:
- Portfolio Management: To determine the expected return of an asset which helps in constructing efficient portfolios.
- Corporate Finance: For calculating the cost of equity when assessing the value of a firm or its investments.
However, CAPM has faced criticism and limitations:
- Empirical Tests often show anomalies where CAPM fails to explain stock returns.
- The assumptions of CAPM are often unrealistic, like the absence of taxes or the homogeneity of investor expectations.
- Multifactor Models have been developed to address some of CAPM's shortcomings by incorporating additional risk factors.
Further Reading and Sources
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