Capital Asset Pricing Model (CAPM) Key Terms
Explanation of key terms used when working with the CAPM model
The capital asset pricing model definition bases itself on the assumption that investors have an aversion to high risk factors, so the object is to achieve the greatest rate of return on an investment with the lowest possible risk. If there is a high level of risk, the possibility of gains should be high, too.CAPM works off some set assumptions like market equilibrium, equal access to information, no transaction costs and investors that are rational. Given the detailed definition and assumptions, it is necessary to understand capital asset pricing model (CAPM) key terms for proper usage. Below are groupings of important key terms to consider.
1. Two categories of risk associated with capital asset pricing model
2. Beta variable of capital asset pricing model formula
3. Additional risks with capital asset pricing model formula
Learn about systematic and unsystematic risk in the capital assets pricing model
In general, risk is the possibility of a loss, and, when referring to capital asset pricing model, risk addresses the likelihood of financial loss due to an investment. Therefore, when the definition of CAPM discusses risks, it typically refers to systematic and unsystematic risk. Systematic risk involves an entire group of market portions where the value shifts because of economic changes in the overall market, and unsystematic risk notes the risk of loss attributed to a specific investment.
Try: For an in-depth look at risk and the investor, see the paper provided by The Tuck School of Business at Dartmouth. For a discussion of risk including the risk assumed when using the CAPM created by William Sharpe, see Crestmont Research.
Attach a value to risk of return through the Beta coefficient in the CAPM formula
When discussing risk and return with the capital asset pricing model formula, the Beta variable accounts for the risk attached to a company connected with stock market. If the Beta is a four, the risk is four times higher than the general market. Take a look at the formula to understand what the parts mean: r = Rf + Beta x (RM - Rf), r is the rate of return, Rf is the rate of return on a risk-free investment, B is the Beta (systematic risk) and RM is an educated guess as to the expected rate of return within the stock market.
Try: Wake Forest University School of Law provides an explanation of risks and how the Beta coefficient measures volatility. For an example of using the CAPM formula with an explanation of the limitations, see TeachMeFinance.com.
Explore other risks associated with the capital asset pricing model formula
When looking at the variables in the formula, notice the self-explanatory terms including expected rate of return, market rate of return and the previously explained systematic risk. Look at the risk-free rate of return (Rf) and risk premium (Beta x (Rm - Rf)). The risk-free rate of return is a theory-based return with no risk involved, such as U.S. Government Bonds insured by the government (no loss on this investment). The risk premium is the rate of return an investor expects above the risk-free rate.
Try: Russell Investments presents an explanation of CAPM basic formula variables. For a view of formula variable details with emphasis on risks, see thismatter.com.
- Use websites that provide a CAPM calculator to help with your CAPM calculation.
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