The Capital Asset Pricing Model (CAPM) is a pivotal financial theory that helps in determining the expected return on an investment by considering its risk. It involves the risk-free rate, the beta coefficient, and the expected market return. CAPM's formula, assumptions, and its global perspective with ICAPM are discussed, alongside its strengths, weaknesses, and practical applications in corporate finance and investment valuation.
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CAPM is a widely used model in finance that helps quantify the expected return on an investment based on its risk
Time value of money
Investors are compensated for the time value of money, meaning the potential return they could have earned by investing elsewhere
Additional risk
Investors are also compensated for taking on additional risk, as reflected in the beta coefficient
CAPM is an essential tool for determining the risk-adjusted required rate of return for different assets, guiding investment decisions
The risk-free rate is the theoretical return of an investment with no risk, often associated with government bonds
The beta coefficient measures an investment's sensitivity to market movements, indicating its relative market risk
The expected market return is the return that investors generally expect from the market as a whole, typically estimated by the performance of a major market index
CAPM is based on assumptions such as rational and risk-averse investors, shared investment horizon, and access to all necessary information without costs or taxes
The idealized assumptions of CAPM may not always align with real-world conditions, leading to discrepancies between expected and actual returns
The CAPM formula calculates the expected return as the sum of the risk-free rate and the risk premium, determined by the investment's beta and the market risk premium
CAPM is valuable in corporate finance for estimating the cost of equity capital and in investment valuation, such as assessing the expected return on a new project
CAPM has practical applications in various areas of finance, informing strategic financial planning and investment analysis
00
The CAPM formula, ______ = ______ + βi(______ - ______), is used to determine the risk-adjusted required rate of return on assets.
ERi
Rf
ERm
Rf
01
Risk-Free Rate (Rf) in CAPM
Theoretical return of a riskless investment, often linked to government bonds.
02
Beta Coefficient (β) Significance
Measures investment's sensitivity to market; >1 means more volatile, <1 means less.
