The Capital Asset Pricing Model (CAPM) is a financial formula that determines the theoretical required rate of return for an asset. It’s based on the idea that compensation for risk should be commensurate with the level of risk taken. The formula involves several inputs, including the risk-free rate, the asset’s beta, and the expected market return. To illustrate, suppose the risk-free rate is 2%, the beta of a stock is 1.5, and the expected market return is 8%. The result would be a required rate of return of 11% (2% + 1.5 * (8% – 2%)).
This method provides a standardized approach to evaluating investments and is valuable in assessing if the potential return justifies the associated risk. Investors and financial analysts use it to make informed decisions regarding asset allocation and portfolio construction. Its use helps determine if a security is fairly valued, undervalued, or overvalued compared to its risk profile. While the formula offers a theoretical framework, it’s important to recognize that the validity of its output depends on the accuracy of its input parameters.
