What is the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between risk and expected return of an investment. The model provides a framework for determining the expected return on an investment given the risk-free rate of return, the expected market return, and the asset’s beta, which is a measure of the asset’s volatility or sensitivity to market movements.

According to the CAPM, the expected return on an asset is equal to the risk-free rate plus a premium that compensates for the risk of the asset. This premium is determined by the asset’s beta and the difference between the expected market return and the risk-free rate. The CAPM assumes that all investors are rational and have access to the same information and that the market is efficient, meaning that asset prices reflect all available information.

The CAPM is widely used in finance as a tool for evaluating investment opportunities, estimating the cost of capital, and determining the expected return on an asset. However, it has been subject to criticism for its assumptions and limitations, including its reliance on market efficiency and the difficulty of estimating beta accurately.