What are the components of the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between systematic risk and expected return for assets, particularly stocks. This model is foundational for investors to understand how much return they should expect for the risk they are taking on through their investments.

The components of CAPM are specifically the risk-free rate, beta, and market risk premium.

• The risk-free rate represents the return on an investment that carries no risk of financial loss, commonly associated with government bonds like U.S. Treasury bills. It serves as the baseline return that investors expect from a risk-free investment.

• Beta measures the sensitivity of an asset’s returns to the returns of the overall market. A beta greater than 1 indicates that the asset is more volatile than the market, while a beta less than 1 indicates it is less volatile. This component helps investors gauge the risk associated with a specific investment in relation to market movements.

• The market risk premium is the additional return that investors demand for taking on the higher risk of investing in the stock market compared to risk-free assets. It is calculated as the difference between the expected return of the market and the risk-free rate.

Together, these components form the basis for calculating the expected return of an asset