0.00%Expected return on the asset
0.00%Risk premium of the asset
8.00%Expected return of the market
0.00%Risk premium of the market
The risk-free rate is usually the rate of a government bond, such as a 30-year Treasury Bill.
This is usually the historical return of a market benchmark such as the S&P 500.
|Benchmark||Historical return||Time period of return|
1957 to 2018
1999 to 2019
Dow Jones Industrial Average
1896 to 2018
1999 to 2019
1999 to 2019
Beta is the level of the asset return's sensitivity compared to the market. For example:
Beta <= −1
Asset moves in opposite direction as the market. Movement is greater than market.
−1 < Beta < 0
Asset moves in opposite direction as the market.
|Beta = 0|
No correlation between asset and market.
0 < Beta < 1
Asset moves in same direction as market.
|Beta = 1|
Asset and market are perfectly correlated. Both both in the same direction by the same amount.
Beta > 1
Asset moves in same direction as market. Movement is greater than market.
The Capital Asset Pricing Model (CAPM) is a financial theory that helps to determine the expected return of an asset, such as a stock or bond, by taking into account the asset's risk and the overall level of risk in the market. The model is based on the premise that investors demand a higher return for assets that are riskier, and that the overall level of risk in the market can be quantified by the market's beta coefficient.
The CAPM is often used by financial analysts and investors to evaluate the potential return on an investment and to compare the returns of different assets. It is a useful tool for determining the appropriate level of risk for a given investment and for making informed investment decisions.
The purpose of CAPM is to understand whether an asset is fairly priced relative to its beta and the market premium.
is the expected return on the market
CAPM can also be represented as:
is considered to be the risk premium of the asset
is considered to be the market premium
Let’s go through each of the inputs into the CAPM equation.
The expected return on the asset is what CAPM calculates. This is what an investor expects to earn on the asset over time.
The risk-free rate is the return that an investor can expect to receive on a risk-free investment, such as a U.S. Treasury bond. The beta coefficient is a measure of the risk of an asset relative to the overall market. A beta of 1 indicates that the asset's price will move in line with the market, while a beta greater than 1 indicates higher risk and potential for higher returns. A beta less than 1 indicates lower risk and potential for lower returns.
The expected return on the market is the return of a market benchmark, such as the S&P 500, Russell 2000, Dow Jones Industrial Average, or another benchmark that encompasses most of the market.
Investors generally use the historical rate of return for the S&P 500, which was 8% between 1957 and 2018.
An asset’s beta measures the risk involved with investing in the asset relative to the market risk and the risk-free rate.
Beta reflects the sensitivity of the asset to the market risk. A beta of 1 signifies that the asset has the same risk as the market. When the market goes up a little, the asset goes up a little. When the market goes down a lot, the asset goes down a lot. The two are perfectly correlated.
A beta of 0 means the asset and the market are not at all correlated. The two move independently of each other.
A positive beta means the asset and the market move in the same direction, while a negative beta means the two move in opposite directions.
The risk premium of the asset is the difference between its expected return and the risk-free rate.
The market premium is the difference between the expected return of the market and the risk-free rate.
One of the key assumptions of the CAPM is that investors are rational and will seek to maximize their expected returns while minimizing their risk. This means that they will be willing to accept higher levels of risk if they expect to receive a higher return.
The CAPM has been widely used in finance and has contributed to the development of many other financial models and theories. However, it has also been the subject of criticism, with some arguing that it does not accurately reflect the complexity of financial markets and that it relies on too many assumptions. Despite these criticisms, the CAPM remains an important tool for financial analysts and investors.