Capital Asset Pricing Model

Valuing stocks, securities, derivatives and/or assets by relating risk and expected return. Explanation of Capital Asset Pricing Model (CAPM) of William Sharpe. 
The Capital Asset Pricing Model (CAPM) is an economic model for valuing stocks, securities, derivatives and/or assets by relating risk and expected return. CAPM is based on the idea that investors demand additional expected return (called the risk premium) if they are asked to accept additional risk. Description of CAPM. The Capital Asset Pricing Model is explained.CAPM was introduced by Treynor ('61), Sharpe ('64) and Lintner ('65). By introducing the notions of systematic and specific risk, it extended the portfolio theory. In 1990, William Sharpe was Nobel price winner for Economics. "For his contributions to the theory of price formation for financial assets, the socalled Capital Asset Pricing Model (CAPM)." The CAPM model says that the expected return that the investors will demand,
is equal to: the rate on a riskfree security plus a risk premium. If the
expected return is not equal to or higher than the required return, the investors
will refuse to invest and the investment should not be undertaken. CAPM formulaThe CAPM formula is: Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium) or: { Another version of the formula is: rRf = Beta x (RM  Rf) }
Beta is the overall risk in investing in a large market, like the New York Stock Exchange. Beta, by definition equals 1,00000 exactly. Each company also has a Beta. The Beta of a company is that company's risk compared to the Beta (Risk) of the overall market. If the company has a Beta of 3.0, then it is supposed to be 3 times more risky than the overall market. Beta indicates the volatility of the security, relative to the asset class. Investing in individual securitiesA consequence of CAPM thinking is that it implies that investing in individual stocks is useless, because one can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class. This is why diehard followers of CAPM avoid securities, and instead build portfolios merely out of lowcost index funds. Assumptions of the Capital Asset Pricing ModelNote! The Capital Asset Pricing Model is a ceteris paribus model. It is only valid within a special set of assumptions. These are:
Normally, all of the assumptions mentioned above are neither valid nor fulfilled. However, CAPM anyway remains one of the most used investments models to determine risk and return. Book: William F. Sharpe  Portfolio Theory and Capital Markets  Book: Harry M. Markowitz  MeanVariance Analysis in Portfolio Choice and Capital Markets  Book: Mary Jackson  Advanced modelling in finance using Excel and VBA 
Compare with: Real Options  RAROC  Plausibility Theory  Operations Research  Strategic Risk Management  Relative Value of Growth  Cost of Equity  Cost of Capital Return to Management Hub: Decisionmaking & Valuation  Finance & Investing 

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