CAPM Financial Model Overview

A model in finance that calculates the expected return of an asset based on its risk, the expected return of the market, and the risk-free rate of return.

Only risks that cannot be eliminated through diversification are considered in CAPM.

A measure of an asset's sensitivity to market risk.

The return that can be earned on a risk-free investment, such as a government bond.

The expected return of the overall market, often represented by a broad market index.

CAPM assumes that investors are rational and only consider the first two moments of a probability distribution (mean and variance) when making decisions.

The relationship between risk and return, where higher risk is expected to be associated with higher return.

A graphical representation of the relationship between risk and return, showing the expected return for different levels of risk.

The Capital Asset Pricing Model (CAPM) is a financial model that calculates the expected rate of return for an asset based on its risk. It assumes that investors require compensation for the time-value of money and the risk they take on.

CAPM assumes that investors are rational and that markets are efficient. It also assumes that all investors have the same information and can borrow and lend money at the risk-free rate.

CAPM helps portfolio managers make informed decisions about which assets to include in their portfolios. It allows them to quantify the risk-return tradeoff for different assets.

The Treynor ratio and Sharpe ratio are both measures of risk-adjusted performance. They can give conflicting rankings because they use different measures of risk.

The risk-return proportionality ratio measures the relationship between risk premium and risk. A higher ratio indicates a greater return for each unit of risk.

Beta measures the volatility of a security's return relative to the market return. A beta of 1 means the security moves in line with the market, while a beta greater than 1 indicates higher volatility.

The Capital Market Line (CML) shows the efficient frontier of portfolios, which means it identifies the best possible risk-return combinations for portfolios. The CML provides a useful benchmark for evaluating portfolios.

Systematic risk, also known as market risk, affects the entire market and cannot be diversified away. Examples include economic recessions, interest rate changes, and inflation.

Unsystematic risk, also known as specific risk, is unique to a particular company or investment. It can be reduced or eliminated by diversification.

Covariance measures how two variables (in this case, returns of a security and the market portfolio) move together. A positive covariance means returns move in the same direction, while a negative covariance means they move in opposite directions.

The expected return of a security is influenced by several factors, including the risk-free rate of return, the market risk premium, and the security's beta. This relationship is represented by the SML equation.

The Capital Asset Pricing Model (CAPM) is a financial model that calculates the expected return of an asset based on its risk and the market's risk-free rate. It assumes investors are rational and make decisions based on risk and return.

The CAPM assumes that all investors are rational and make decisions based on risk and return. It also assumes that investors can borrow and lend at the risk-free rate.

Bonds, which are considered less risky than stocks, do not fall on the Security Market Line (SML) because they offer a different type of risk profile.

The CAPM focuses on market risk. Investors should focus on the overall riskiness of their assets.

The CAPM helps investors select securities and portfolios. High-return assets are considered undervalued, and low-return assets are considered overvalued.

Critics argue that the CAPM is not always accurate and that it uses past data (ex-post) to make future predictions (ex-ante).

Arbitrage Pricing Theory (APT) is a model that explains asset prices based on multiple macroeconomic factors that influence asset returns.

APT expands on the CAPM by incorporating various macroeconomic factors that influence returns, such as inflation and economic growth. It uses factor betas to measure the sensitivity of asset returns to each factor.

The idea that the historical volatility of a security is a good predictor of its future volatility. This is often used to estimate future beta.

The tendency for individual stock betas to be unstable over time, making them unreliable indicators of future risk.

The observation that betas of portfolios made up of many stocks (10 or more) tend to be more stable than individual stock betas. This is because errors in individual beta estimates tend to cancel each other out in a diversified portfolio.

The empirical finding that the relationship between expected return and systematic risk (beta) is generally positive but the slope of the relationship (the reward for taking on risk) is often lower than predicted by the CAPM.

The empirical finding that, while there appears to be a positive relationship between risk and return, it is generally linear. There is no significant curvature in the relationship.

The empirical finding that both systematic and unsystematic risks (market and company-specific risks) are positively related to security returns, contradicting the CAPM's assumption that only systematic risk matters.

An argument by Richard Roll claiming that the CAPM is untestable because it is difficult to accurately define and measure the true market portfolio.

CAPM assumes investors are rational, risk-averse, and aim to maximize utility by making diversified investments.

A version of CAPM that does not assume a risk-free asset, making it more robust and widely used.

The expected return on a portfolio is the weighted average of the returns of the individual assets within the portfolio.

CAPM assumes investors can borrow or lend unlimited amounts at a risk-free rate, creating a diversified portfolio.

CAPM assumes investors have homogeneous expectations, meaning everyone has the same information about investments.

CAPM assumes investors are price takers, meaning they don't affect the price of an asset through their trades.

CAPM assumes all securities are highly divisible and have low transaction costs, making trading easy.