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An estimation of the CAPM and the security market line (purple) for the Dow Jones Industrial Average over 3 years for monthly data.. In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.
Here’s how the capital asset pricing model works.
It is commonly computed using the capital asset pricing model formula: Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return) where Beta = sensitivity to movements in the relevant market. Thus in symbols we have
[10] [11] The CAPM, for example, can be derived by linking risk aversion to overall market return, and restating for price. [9] Black-Scholes can be derived by attaching a binomial probability to each of numerous possible spot-prices (i.e. states) and then rearranging for the terms in its formula.
For the latter, various models have been developed, where the premium is (typically) calculated as a function of the asset's performance with reference to some macroeconomic variable – for example, the CAPM compares the asset's historical returns to the "overall market's"; see Capital asset pricing model § Asset-specific required return and ...
Security market line (SML) is the representation of the capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk. The risk of an individual risky security reflects the volatility of the return from the security rather than the return of the market ...
Generalizing the above definition to the multifactor setting, Jensen's alpha is a measure of the marginal return associated with an additional strategy that is not explained by existing factors. We obtain the CAPM alpha if we consider excess market returns as the only factor.
CAPM may refer to: Capital asset pricing model, a fundamental model in finance; Certified Associate in Project Management, an entry-level credential for project managers