CAPM

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Definition

Capital Asset Pricing Model (CAPM) was introduced by Jack Treynor, William Sharpe, and John Litner independently building on work done by Harry Markowtiz's efficiency frontier theories.

The CAPM postulates that the return of an asset is dependent on an asset's beta (correlated volatility of an asset in relation to the benchmark) and the return of a risk-free rate.

Formula

An illustrated simple example : If a company's stock had a beta of 1.2, the market risk premium was 4% and the risk-free rate was 5%, the company's stock would have an expected return of 5% +1.2 (4%)=9.8%.

In practice (and not practice problems), this rarely holds in financial markets. While CAPM assumes diversification to remove idiosyncratic risk, the use of a single variable to predict expected returns has not always been historically accurate. Both the risk-free rate and the market risk premium used in CAPM are arguably subject to swings during times of increased financial volatility.

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