The Capital Asset Pricing Model (CAPM) is a widely-used financial model that attempts to explain the relationship between risk and expected return for individual securities or portfolios.
The basic intuition behind the CAPM is that investors demand a higher return for taking on higher levels of risk. In other words, if investors can invest in a security with lower risk and achieve the same return as a security with higher risk, they would prefer the lower-risk security. The CAPM provides a way to quantify how much extra return investors should expect to receive for taking on additional risk.
The CAPM formula can be expressed as:
E(Ri)β=βRfβ
+β
Ξ²i(E(Rm)β
ββ
Rf)
where:
- E(Ri) is the expected return for security i
- Rf is the risk-free rate of return
- Ξ²i is the systematic (market) risk of security i
- E(Rm) is the expected return of the market portfolio
The basic idea is that the expected return for a security is equal to the risk-free rate plus a risk premium, where the risk premium is proportional to the systematic (market) risk of the security, as measured by its beta.
In practice, the CAPM is often used to estimate the expected return of a security or portfolio, given its estimated beta and the market risk premium (i.e. the difference between the expected return of the market portfolio and the risk-free rate). This expected return can then be used as a benchmark for evaluating whether the security or portfolio is overvalued or undervalued, based on its current market price.
The CAPM has some limitations, including the assumption of a single factor (the market) driving security returns, and the assumptions of rational and homogeneous investors. However, it remains a widely-used tool in finance for evaluating risk and return, particularly in the context of portfolio management and asset pricing.