gen-define-the-capital-asset-pricing-model-and-give-one-short-wo-b440

Define the capital asset pricing model and give one short worked example.

# Capital Asset Pricing Model (CAPM) ## Definition The **Capital Asset Pricing Model** is a financial model that establishes the relationship between systematic risk and expected return for assets, particularly stocks. It calculates the expected return on an investment based on its risk relative to the overall market. ## Formula **E(Ri) = Rf + βi × [E(Rm) - Rf]** Where: - **E(Ri)** = Expected return on investment i - **Rf** = Risk-free rate of return - **βi** = Beta of the investment (systematic risk measure) - **E(Rm)** = Expected return of the market - **[E(Rm) - Rf]** = Market risk premium ## Worked Example **Given:** - Risk-free rate (Rf) = 3% - Expected market return E(Rm) = 10% - Stock beta (β) = 1.5 **Calculate the expected return:** E(R) = 3% + 1.5 × (10% - 3%) E(R) = 3% + 1.5 × 7% E(R) = 3% + 10.5% **E(R) = 13.5%** **Interpretation:** This stock is expected to return 13.5% because it's 50% more volatile than the market (beta = 1.5), so investors require a higher return to compensate for the additional systematic risk.