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Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is the product of a financial investment theory that reflects the relationship between risk and expected return. The model assumes a linear relationship.

The formula for calculating expected return is:

formula-for-calculating-expected-return.JPG

The CAPM is used to forecast returns that can be obtained with risk-bearing asset classes. The linear relationship means that taking extra risk will on average lead to higher returns.

However, empirical tests performed in the early seventies* with this model showed that the relationship between risk and return is less strong than the theory indicates.

* The first study performed by Haugen and Heins: ‘On the Evidence Supporting the Existence of Risk Premiums in the Capital Market’ (1972), demonstrates that over the period 1929 - 1971, low-volatility equities realized extra risk-adjusted returns.
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