Capital Asset Pricing Model (CAPM)

Lesson

The Capital Asset Pricing Model (CAPM) is a widely-used finance theory that establishes a linear relationship between the expected return of an asset and its risk, as measured by beta. It is used to determine an asset's appropriate required rate of return, given the risk-free rate, the expected market return, and the asset's beta.

Practice Question #1

Which of the following best describes the Capital Asset Pricing Model (CAPM)?

A) A theory that focuses on optimizing a portfolio's risk and return through diversification.

B) A theory that suggests all available information is already reflected in asset prices.

C) A theory that establishes a linear relationship between the expected return of an asset and its risk, as measured by beta.

D) A multi-factor model that explains the relationship between an asset's expected return and various macroeconomic factors.

Select an option above to see an explanation here.

A) This describes Modern Portfolio Theory (MPT). B) This describes the Efficient Market Hypothesis (EMH). C) This is the correct definition of the Capital Asset Pricing Model (CAPM). D) This describes the Arbitrage Pricing Theory (APT).

Terms

CAPM:: Capital Asset Pricing Model, a theory that describes the relationship between risk and expected return of an asset.
Expected return:: The return an investor anticipates receiving from an investment.
Risk-free rate:: The return on investment with zero risk, typically represented by a government bond.
Beta:: A measure of an asset's risk relative to the market, with a beta of 1 indicating the asset moves in line with the market.
Market return:: The market's overall return, typically represented by a broad market index.
Required rate of return:: The minimum return an investor requires to invest in an asset, given its risk.

Practice Question #2

What does a beta of 1.2 indicate about an asset's risk relative to the market?

A) The asset is less risky than the market.

B) The asset is riskier than the market.

C) The asset has no risk.

D) The asset's risk cannot be determined.

Select an option above to see an explanation here.

A) A beta of less than one would indicate the asset is less risky than the market. B) A beta greater than one indicates the asset is riskier than the market. C) A beta of 0 would indicate no risk. D) Beta measures an asset's risk relative to the market.

Historical Example

In the 1970s, the CAPM was widely adopted by investment professionals to help determine the appropriate required rate of return for individual stocks. This led to a greater focus on risk management and diversification in investment portfolios.

Practice Question #3

Which type of risk can be diversified away?

A) Systematic risk

B) Unsystematic risk

C) Both systematic and unsystematic risk

D) Neither systematic nor unsystematic risk

Select an option above to see an explanation here.

A) Systematic risk affects the entire market and cannot be diversified away. B) Unsystematic risk is specific to an individual asset and can be diversified away. C) Only unsystematic risk can be diversified away. D) Unsystematic risk can be diversified away.

Real-World Example

An investor is considering investing in a stock with a beta of 1.5. The risk-free rate is 2%, and the expected market return is 8%. Using the CAPM, the investor can calculate the required rate of return as follows: 2% + 1.5 * (8% - 2%) = 11%. This means the investor requires an 11% return to invest in the stock, given its risk.

Practice Question #4

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Example Series 65 Example Practice Question

Formulas to Remember

CAPM: E(Ri) = Rf + Beta * (E(Rm) - Rf) Where: E(Ri) = Expected return on the investment Rf = Risk-free rate Beta = a measure of the investment's volatility relative to the market E(Rm) = Expected return on the market

Practice Question #5

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Example Series 65 Example Practice Question

Formula Examples

Suppose we have the following information: Risk-free rate (Rf) = 2% Beta = 1.5 Expected return on the market (E(Rm)) = 8% Using the CAPM formula: E(Ri) = Rf + Beta * (E(Rm) - Rf) E(Ri) = 2% + 1.5 * (8% - 2%) E(Ri) = 2% + 1.5 * 6% E(Ri) = 2% + 9% E(Ri) = 11%