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The Capital Asset Pricing Model (CAPM)

From Theory To Practice

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

The Capital Asset Pricing Model (CAPM) is one of the most important discoveries in all of academic finance. Some academics swear by this model, while others believe it to be completely worthless. Either way, it’s impact on the field of finance is undeniable. In fact, the beta that we all use every single day to weight our portfolios is an output from the CAPM.

The CAPM’s intention is to model stock returns in a univariate regression model, where the market return is the only variable that is determined to impact a stock’s return. The coefficient on the market return that outputs from the model is beta, and it is the direct connection between the overall market and an individual stock. What we see when we dig a little deeper is an equity with a beta of one has the same amount of risk as the overall market, a beta over one is more risky than the market, and a beta under one is less risky than the market.

Given all of this, the CAPM carries a host of assumptions. Some of these are reasonable, while others are a bit farfetched. Therefore, we will look to improve upon this model in the near future.

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