importance of capital asset pricing model

It can be defined as a given assumption regarding the trajectory of investment over course of its life. See also Short-term Finance: Types, Disadvantages, and AdvantagesĮxpected Return: Expected Return can be defined as the return of capital assets over the course of time. Components of CAPMĪs mentioned earlier, it can be seen that CAPM comprises four main components: expected return, risk-free rate, an underlying beta of the security, and the risk premium involved.

This can be explained by the fact that when investing, investors need to ask for a greater risk premium when they take on investments that are riskier as compared to others. In this regard, a risk premium is regarded as a higher return rate that is in excess of the risk-free rate. It mainly lies in the fundamentals of systematic risk, which lies on the premise that investors need to justify their investments using risk premiums. The CAPM formula is used in order to compute the expected returns on an asset. R a = Expected return on the given Security (a) In the above formula, it can be seen that Formula:ĬAPM is calculated with the formula given below: The Capital Asset Pricing Model is designed in order to describe the relationship lying between expected return and the underlying risk behind investing in a given security. It is used in the field of finance in order to price securities that have a higher risk profile, in addition to generating expected returns for assets, using the underlying risk, as well as the cost of capital for that particular decision. The Capital Asset Pricing Model can be referred to as a tool that describes the existing relationship between systematic risk and expected return for assets, including stocks.

Importance of capital asset pricing model