Capital Asset Pricing Model Flashcards, test questions and answers

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What is Capital Asset Pricing Model?

The Capital Asset Pricing Model (CAPM) is a model used in finance to determine the expected return of an asset based on its risk. It attempts to balance the risk and return of an investment portfolio by calculating the expected rate of return for a particular asset based on its level of risk. The CAPM is one of the most widely used models in modern finance and is used by investors, financial analysts, and portfolio managers when making decisions about investments.The CAPM assumes that all investors are rational and have access to perfect information about all assets, allowing them to make optimal decisions about which assets will give them the highest expected return for their chosen level of risk. The model states that the expected return on an asset is equal to its required rate of return plus a premium for taking on additional risk. The required rate of return is determined by a security’s market beta, which measures how volatile an asset’s returns are compared to those of a broader market index. Higher betas indicate higher levels of volatility and thus higher potential returns. The CAPM also incorporates diversification into its calculation by accounting for systematic risksi.e., risks that cannot be reduced through diversificationthat cannot be eliminated through portfolio diversification alone but must instead be accepted as part of investing in any given asset or set of assets. This diversification allows investors to reduce their overall exposure to unsystematic risks while still potentially earning higher returns than they would from staying completely within safe investments with lower returns but no extra risks taken on due to their lack of diversification across multiple types or classes assets.