Short definition: The Capital Asset Pricing Model (CAPM) is a financial model used to determine the expected return on an investment based on its systematic risk.
Explanation: CAPM calculates the expected return of an asset by considering the risk-free rate, the asset’s beta (a measure of its volatility relative to the market), and the expected market return. It provides a framework for investors to assess the risk and return tradeoff of different investments.
Example: If a stock has a beta of 1.2, the risk-free rate is 3%, and the expected market return is 8%, the CAPM would estimate the expected return on the stock to be 9% (3% + 1.2 * (8% – 3%)).
Additional information (optional): CAPM is a widely used model in finance and investing, but it has been criticized for its simplifying assumptions and limitations. Despite its shortcomings, it remains a valuable tool for understanding the relationship between risk and return.