Capital asset pricing model

Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is a model that describes the relationship between risk and expected return for assets. It is a widely used model in finance and investment theory.

The CAPM states that the expected return of an asset is equal to the risk-free rate of return plus a risk premium. The risk premium is the additional return that investors demand for taking on the risk of the asset.

The risk premium is calculated as the product of the beta of the asset and the market risk premium. The beta of an asset is a measure of its volatility relative to the market. The market risk premium is the difference between the expected return of the market and the risk-free rate of return.

Formula for CAPM

The formula for the CAPM is:

E(r) = r f + β(r m − r f)

where:

  • E(r) is the expected return of the asset
  • r f is the risk-free rate of return
  • β is the beta of the asset
  • r m is the expected return of the market

MCQs on Capital Asset Pricing Model

  1. Which of the following is not a factor that affects the beta of an asset?
    • The volatility of the asset
    • The correlation of the asset with the market
    • The risk-free rate of return
    • The market risk premium

The answer is The risk-free rate of return. The risk-free rate of return does not affect the beta of an asset. The beta of an asset is a measure of its volatility relative to the market. The risk-free rate of return is the return of an asset that is free of risk.

  1. Which of the following is the market risk premium?
    • The difference between the expected return of the market and the risk-free rate of return
    • The difference between the expected return of an asset and the risk-free rate of return
    • The product of the beta of an asset and the market risk premium
    • The volatility of an asset

The answer is The difference between the expected return of the market and the risk-free rate of return. The market risk premium is the additional return that investors demand for taking on the risk of the market.

Conclusion

The CAPM is a useful model for understanding the relationship between risk and return. It can be used to help investors make informed investment decisions.

Here are some additional tips for using the CAPM:

  • Use a reliable source for the beta of the asset.
  • Consider the time horizon of the investment.
  • Consider the risk tolerance of the investor.
  • Use the CAPM as a guide, not a guarantee.