Define: Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM), originated in the early to mid-1960s, was built upon the concept of modern portfolio theory and diversification. The capital asset pricing model 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 that asset’s non-diversifiable risk.

Capital Asset Pricing Model (CAPM) is a sophisticated mathematical method of formulating a relationship between expected risk and expected return.

In essence, the Capital Asset Pricing Model is built on a pervasive investment theory, in which the Capital Asset Pricing Model claims that higher risk justifies higher returns. Building upon that assertion, the Capital Asset Pricing Model states that the return on an asset or security is equal to a risk-free return, plus a risk premium. Thus, according to the Capital Asset Pricing Model, the projected return must be on par with or above the required return to rationalize the investment. End calculation of the Capital Asset Pricing Model is conveyed graphically by the security market line (SML). Capital Asset Pricing Model is a fairly complicated device used primarily by trained financial practitioners to calculate the pricing of high-risk securities.

The CAPM takes into account the following:

• the asset’s sensitivity to non-diversifiable risk (also known as systematic risk or market risk);
• the expected return of the market; and
• the expected return of a theoretical risk-free asset.

Return

Return represents the expected value that can be paid, and is referred to as “r”.

Risk

Risk indicates the danger of losing the investment, or standard deviation (sigma).

Risk-free investment

As indicated by rf, this is the equivalent of treasury bills or bank savings. In order to be on the capital market line, one must have an investment in rf. These are considered ‘efficient portfolios’.

M

Portfolio M is the market portfolio, which contains all securities, each in proportion to its outstanding or market value. In practice, one must select a benchmark portfolio, such as the S&P 500 or the Russel 5000, as it is impossible to invest in absolutely everything simultaneously.

The capital market line is an element of the capital asset pricing model. The CML is used to evaluate portfolio performance.

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Definitions for Capital Asset Pricing Model are sourced/syndicated and enhanced from:

• A Dictionary of Economics (Oxford Quick Reference)
• Oxford Dictionary Of Accounting
• Oxford Dictionary Of Business & Management

This glossary post was last updated: 26th March, 2020