In finance, the capital asset pricing model (or CAPM) is a model or framework that helps theoretically assess the rate of return required for an asset to building a diversified portfolio able to give satisfactory returns. The CAPM is given by the risk-free rate + the Beta of the asset in which we invested multiplied by what is called the market risk premium (provided by the expected return of the market portfolio minus the risk-free rate).
Above how the whole CAPM Formula looks like, and below its breakdown:
The expected return of an asset is given by the risk-free rate + the Beta of the asset in which we invested multiplied by what is called the market risk premium (provided by the expected return of the market portfolio minus the risk-free rate).
To compute the expected return of an asset we have to assess three variables:
- Risk-free rate.
- The expected return of the market.
Beta (CAPM) formula
The formula to compute our Beta is given by:
The covariance is a statistical measure that allows us to understand if two variables are positively or negatively correlated. For instance, a positive covariance means that two variables move in the same direction, and vice versa.
The variance instead is a statistical measure that shows how values move away from the mean. Thus, it shows how values are spread around the mean. In fact, when there are larger moves around the mean, this also makes the stock riskier.
While CAPM and Beta are measured still used in the academic world, real-world practitioners might not rely on these measures as they can be misleading. Markets follow random variations and often a fat-tail distribution, where there is no average, or where it takes a long-time for an average to form in the first place. Therefore the whole toolbox based on standardized measures (Beta, CAPM, WACC) might look good on paper, but it might be useless or bad for real-world decision-makers.