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Explain Capital Asset Pricing Model Formula

The Capital Asset Pricing Model (CAPM) is used to determine the expected return of an investment based on its risk relative to the overall market. The formula incorporates the risk-free rate, the asset's beta, and the market risk premium to adjust the expected return for the asset's individual risk. CAPM emphasizes that only systematic risk is relevant for returns, as unsystematic risk can be diversified away.

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Chandra Prakash 11 A 45
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17 views2 pages

Explain Capital Asset Pricing Model Formula

The Capital Asset Pricing Model (CAPM) is used to determine the expected return of an investment based on its risk relative to the overall market. The formula incorporates the risk-free rate, the asset's beta, and the market risk premium to adjust the expected return for the asset's individual risk. CAPM emphasizes that only systematic risk is relevant for returns, as unsystematic risk can be diversified away.

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Chandra Prakash 11 A 45
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explain Capital asset pricing model formula

The Capital Asset Pricing Model (CAPM) is a fundamental concept in quantitative finance used
to determine the expected return of an investment, given its risk compared to the overall
market. The CAPM formula is:

where:
$ E[r_a] $: Expected return of asset $ a $ (such as a stock or a portfolio)
$ r_f $: Risk-free rate of return (typically the return on government bonds)
$ \beta_a $: Beta of asset $ a $, which measures the sensitivity of the asset’s returns to the
returns of the overall market
$ E[r_m] $: Expected return of the market (for example, the S&P 500 index)
$ (E[r_m] - r_f) $: Market risk premium, the extra return investors expect for taking on risk
over the risk-free rate

Explanation of the Formula


The risk-free rate ($ r_f $) is the baseline return you could get with zero risk.
$ \beta_a $ quantifies how much risk the asset has relative to the market. A beta of 1 means
the asset moves in line with the market. Greater than 1 means it is more volatile/riskier than
the market, less than 1 means it is less volatile.
The market risk premium ($ E[r_m] - r_f $) reflects the additional return investors require for
choosing a risky market portfolio over a risk-free investment.
By multiplying the beta by the market risk premium, the formula adjusts the required return
for the asset’s individual risk.
The total expected return combines the risk-free rate with the asset’s compensation for
market risk.

Core Intuition
CAPM states that the only kind of risk that matters for returns is systematic (market) risk, not
unsystematic (individual asset-specific) risk, because the latter can be diversified away. Only
assets that add risk to a well-diversified portfolio (measured by beta) should earn a risk
premium.
Key Takeaways
CAPM helps price risky securities and generate expected returns.
The formula is based on historical data but assumes markets operate efficiently and
investors behave rationally.
Beta is central: It is calculated as the covariance of the asset’s return with the market’s
return divided by the variance of the market’s return.
The formula is widely used for estimating cost of equity and in portfolio construction [1] [2] .

1. quant_finance.pptx
2. quantitative_finance.pptx

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