Capital Asset Pricing Model (CAPM) Calculator
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The Capital Asset Pricing Model (CAPM) is a foundational concept in finance that helps in understanding the relationship between risk and return in the financial markets. It provides a formula that investors can use to evaluate the expected return of an asset, considering its risk in relation to the market.
Historical Background
CAPM was introduced in the 1960s by Jack Treynor, William F. Sharpe, John Lintner, and Jan Mossin independently. The model was developed to explain how securities are priced, incorporating the risk associated with market fluctuations and the time value of money. It has since become a cornerstone of modern portfolio theory.
Calculation Formula
The CAPM formula is given by:
\[ E(R_i) = R_f + \beta_i \left[ E(R_m) - R_f \right] \]
where:
- \(E(R_i)\) is the expected return on the investment,
- \(R_f\) is the risk-free rate,
- \(\beta_i\) is the beta of the investment,
- \(E(R_m)\) is the expected market return.
Example Calculation
Assuming a risk-free rate of 2%, a beta of 1.5, and an expected market return of 8%, the expected return on the investment can be calculated as follows:
\[ E(R_i) = 2\% + 1.5 \left[ 8\% - 2\% \right] = 2\% + 1.5 \times 6\% = 2\% + 9\% = 11\% \]
Importance and Usage Scenarios
CAPM is widely used for estimating the return on assets that have not yet been purchased, setting the expected return benchmarks for portfolios, and in the cost of capital calculations for investment appraisal.
Common FAQs
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What does beta represent in CAPM?
- Beta measures the sensitivity of the expected excess asset returns to the expected excess market returns.
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How is the risk-free rate determined?
- The risk-free rate is typically represented by the yield on government securities, such as treasury bills, that are considered free from default risk.
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Can CAPM be applied to non-financial assets?
- Yes, CAPM can be applied to any investment that has a measurable beta, including real estate and commodities, though its accuracy might vary across different asset classes.
This calculator facilitates the application of the CAPM formula, making it accessible for both academic and practical purposes in finance and investment analysis.