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Capital Asset Pricing Model (CAPM)
Definition
A model that relates expected return to systematic risk via beta.
How It Works
E(R) = Rf + β(Rm-Rf). Add a risk premium proportional to beta on top of the risk-free rate.
Formula
E(R) = Rf + β × (Rm - Rf)
Example
With Rf=3%, beta=1.2, and market premium=7%, expected return = 3% + 1.2×7% = 11.4%.
Common Misconceptions
- ✗CAPM works perfectly in all markets
- ✗You can ignore beta if you hold just one stock
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Common questions about Capital Asset Pricing Model (CAPM)
Fama-French 3-factor model, Arbitrage Pricing Theory, and build-up methods.
It is simple, requires only one risk factor (beta), and provides a clear framework for thinking about risk-return trade-offs. For most finance class and practical applications, CAPM produces reasonable estimates.
More Glossary Terms
📉 Discount Rate🧮 Net Present Value (NPV)🎯 Internal Rate of Return (IRR)⚖️ Weighted Average Cost of Capital (WACC)📈 Beta (β)📊 Capital Asset Pricing Model (CAPM)🛡️ Risk-Free Rate💹 Market Risk Premium💲 Cost of Equity🏦 Cost of Debt♾️ Terminal Value💸 Free Cash Flow🏢 Enterprise Value🚧 Hurdle Rate🔁 Annuity♾️ Perpetuity💵 Yield to Maturity (YTM)✂️ Coupon Rate📅 Amortization🔍 Sensitivity Analysis