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CAPM-Capital Asset Pricing Model
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An investment theory according to which investors require higher returns for higher risks.
More specifically, CAPM argues that the expected return on a Security is equal to the Risk-free rate of return plus a Risk Premium. It also suggests that all unsystematic risks can be eliminated by diversifying the Portfolio.
CAPM can be applied to investment strategy in four ways:
(1) in stock selection (calculating a Security market line on the Basis of betas allows one to identify stocks that are mispriced - all stocks off the line are either under priced or overpriced);
(2) in overall market strategy (if an investor thinks the market Will rise, he/she should hold stocks with a High Beta to try to earn above-market returns);
(3) in determining the price of Risk (if an empirical Security market line is flat, the market offers a relatively Low reward for taking on Risk); and
(4) in evaluating a stock selection scheme (betas tell us what the expected return is; if the stocks selected earn a higher-than-expected return, then stock selection was successful).
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| Posted by
Henley & Partners Group Holdings Ltd, Institute for International Research
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