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Capital Asset Pricing Model (CAPM) Basics

Discover the usefulness of CAPM analysis

By Gail L. Perry, Freelance Writer / MSW Life Coach
William Sharpe built the Capital Asset Pricing Model (CAPM) on the theoretical foundation of Harry Markowitz’s portfolio theory. It is important to note that the portfolio theory presented limitations in accuracy because of an oversimplified view of the investment world. Regardless of this simplified foundation, the capital asset pricing model formula remains the most-used investment model for risks and returns, but many expect future changes that increase the accuracy of evaluating investment risks.

The capital asset pricing model definition states that it is a measure of investment risk to investor return. This means that the higher the risk of investment, the higher the expected return for the investor. With the following information, understand capital asset pricing model (CAPM) basics:

1. Learn about risks though the CAPM economic model.

2. Review the capital asset pricing model formula.

3. Use CAPM calculation to discover projected profit.

 

Discover types of economic investment risks through the CAPM model

Capital assets pricing model is an economic model that places value on an investment portfolio by relating risks to the expected return of the investment. It asserts that investors deserve compensation according to the level of risk involved with the investment. It also outlines two types of risks involved with investing: systematic and unsystematic risk.
Try: Contingency Analysis provides information about the development and expectations of the CAPM. Investopedia explains the systematic and unsystematic risk involved when investing.

Learn the elements of the capital asset pricing model formula

The formula for CAPM is: r = Rf + Beta x (RM - Rf), which states that the Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium). While the basis of this formula depends on a diversified portfolio, it still yields useful information when investors are deciding whether the risk of the investment is worth the amount of compensation.
Try: In addition to providing an example of how to use CAPM formula, Business Finance Online provides an overview and an explanation of systematic and unsystematic risks. For a list of specific assumptions made when using the CAPM, see Value Based Management.

Unveil profit possibilities with a capital asset pricing model calculator

The CAPM calculator is useful for managers evaluating possible financial projects because the CAPM calculations expose the rate of return in correlation with the investment risk. This information helps a manager find profitable investments for the company to pursue.
Try: In an entertaining, easy-to-understand explanation of CAPM, Gummy Stuff provides helpful details on how to use the CAPM calculator for maximum benefit. For more CAPM calculator explanation and usage experience, see moneychimp.

 

  • Outline the drawbacks and assumptions associated with the CAPM when presenting a possible project for a business to pursue, so that officials are aware of the limitations within the projected profits.

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