What is Capital Asset Pricing Model?

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The capital asset pricing model (CAPM) is a financial model that is used to calculate the expected return on an investment, based on the risk of that investment relative to the overall market. The model was developed by William Sharpe, John Lintner, and Jan Mossin in the 1960s and is widely used in finance and investment analysis.

The CAPM assumes that the expected return on an investment is equal to the risk-free rate of return (i.e., the return that an investor can earn without taking on any risk) plus a risk premium that is proportional to the risk of the investment. The risk premium is calculated by multiplying the difference between the expected return on the market and the risk-free rate by the investment’s beta, which measures its volatility relative to the overall market.

The CAPM is based on several key assumptions, including the idea that investors are rational and risk-averse, and that they hold diversified portfolios that include all available investments. It also assumes that there are no taxes, transaction costs, or other frictions that would affect investment returns.

The CAPM has been criticized for its reliance on certain assumptions and for its limitations in predicting actual returns. However, it remains a widely used and influential model in finance and investment analysis, and has been used to inform a wide range of investment strategies and decision-making processes.

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