Monday, December 1, 2014

Capital Assets Pricing Model (CAPM)

The CAPM explains the relationship between the expected return , non-diversiable risk & the valuation of securities. It tells the required rate of return of a security on the basis of its contribution to the total risk. It is based on the premise that the diversifiable risk of a security is estimated when more & more securities are added to the portfolio. However, the systematic risk cannot be diversified & is correlated with that of the market portfolio. All securities, do not have same level of systematic risk. thus, the required rate of return goes with the level of systematic risk. The systematic risk, can be measured by Beta. Under CAPM, the expected return from a security can be explained as:

Expected return on security =    Rf + Beta (Rm –Rf)

Rf     = Risk Free Rate of Return
Rm = Market Rate of Return

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