Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model

In 10 words or less: A model that allows you to price stocks and other securities.

Definition:  A model that allows investors to price securities, such as stocks, based on the risk-free rate, market returns, and the security's volatility.  The equation is characterized as:

ER_k = r_f + B_k (ER_p - r_f), where:

ER_k is the expected return on the stock for the year

r_f is the risk free rate of return

B_k is the beta of stock k

ER_p is the expected return on the market portfolio (typically the S&P500)

Advice: As long as you believe that beta is an accurate portrayal of a stock's risk relative to the market, CAPM is a great way to price securities.  Many analysts use it to calculate a stock's cost of equity.

Jonny Boy said:

Jodi - is this right? The capital asset pricing model, also known as CAPM, is an economic model to placing a value on stock, which involves relating risk to the expected return projected. Based on this idea, the investors usually demand expected return, also called a risk premium, when asked to accept uncertain and additional risk. Risk premium is a reward for holding a risky stock or security rather than one that is considered to be risk free. Most investors, unless real gamblers, would rather not hold these risk premiums.