Capital Asset Pricing Model (CAPM) – Introduction
The Capital Asset Pricing Model (CAPM) is the backbone of modern finance. Developed by William Sharpe (Nobel Prize winner), it provides a formula to calculate the expected return of an asset based on its risk.
The Core Concept
CAPM says that investors should be compensated for two things:
- Time Value of Money: The return you get for waiting (Risk-Free Rate).
- Risk: The extra return you get for taking on market risk (Risk Premium).
Note
Key Takeaway: CAPM assumes that you only get paid for taking Systematic Risk (Market Risk). You do NOT get paid for taking Unsystematic Risk (Idiosyncratic Risk) because you could have easily diversified it away for free.
Anatomy of CAPM
The model separates risk into two buckets:
Loading comparison…
Why is it Important?
- Valuation: It tells you the "Discount Rate" to use in DCF analysis.
- Performance Evaluation: Did a mutual fund manager actually beat the market, or did they just take more risk? (Alpha vs Beta).
- Capital Budgeting: Companies use it to calculate their Cost of Equity (Ke).
The Beta (Beta) Concept
Beta measures how sensitive a stock is to market movements.
- Beta = 1: Stock moves exactly with the market.
- Beta > 1: Aggressive (Volatile). if Market is up 10%, Stock is up 15%.
- Beta < 1: Defensive (Stable). If Market is down 10%, Stock is down only 5%.
Loading quiz…