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![]() Typically based on the rate paid on short term federal treasury bills, this interest rate forms the basis for the required rate of return on all assets. The risk free rate of return in the CAPM Capital Asset Pricing Model refers to the rate of return an investor can receive without exposing their funds to any risk. Other models follow this theory, such as the Gordon Model (Constant Dividend Growth), which assumes that price can be determined by the rate of return received by an investor. The CAPM Capital Asset Pricing Model concludes that this is the primary determinant of asset prices in the market. If the asset does not produce the required rate of return, then the price is too high relative to the risk exposure. This risk premium, which is over and above the risk free rate of return, is the required rate of return that an asset must generate in order for anyone to invest in it. Since an investor will always want to expose themselves to the minimum level of risk, they must receive a premium rate of return relative to the amount of risk they are exposed to in any one asset. In the real world, this tends to be based on the rate offered by federal government short term treasury bills, as these are considered to be the closest possible to risk free investments. ![]() The CAPM Capital Asset Pricing Model also assumes that investors can always invest in a risk free asset, which will offer them the minimum possible rate of return for any investment. An asset with a Beta greater than one will expose the investor to higher levels of volatility, but will also reward the investor as the value of the asset will grow at a higher rate than the market. This follows form the basic assumption that the value of the market in the long run will increase. ![]() The CAPM Capital Asset Pricing Model assumes that investors will never accept higher levels of risk (volatility) unless they are to be compensated with a higher expected rate of return. As with the positive Beta, the greater the value of the negative Beta will indicate the degree to which the asset fluctuates inversely to the market. A negative Beta means that the price of the asset tends to decrease when the value of the market increases. It is even possible to have a negative Beta. A Beta with a value of 1 is expected to move to the same degree as the market, a Beta with a value lower than 1 will move to a lesser degree than the market, and a Beta of greater than 1 will move to a higher degree than the market when the market moves. An asset with a high Beta will increase in price more than the market when the market increases, and decrease more than the market when the market decreases. The relationship between the price of any one asset and the value of the market is known as Beta. The CAPM Capital Asset Pricing Model assumes that the volatility of any one asset can be related to the volatility of the market as a whole. A high degree of volatility means that a particular asset (stock) will increase and decrease in price to a higher degree than another asset with less volatility. Volatility refers to the fluctuation in value of the asset, how much the price increases or decreases. When talking of risk in capital assets, we are really talking about their volatility. The “market” is composed of all possible stocks, and is an aggregate of their returns and risk levels. This means that all else being equal, investors will choose the asset that has the highest expected rate of return, and the asset that exposes them to the lowest level of risk possible. When deciding which asset to invest in, investors will look to compare the expected rates of return with the expected levels of risk. When investing these funds, investors put their capital at risk. Investors are looking to generate a return on their funds by choosing assets to invest in with an expected rate of return. The basic assumptions of this model give us insight into how it works. The CAPM Capital Asset Pricing Model is a mathematical model intended to provide insight into how capital assets are priced in the market. What is the CAPM Capital Asset Pricing Model?
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