CAPM Model is the acronym for Capital Asset Pricing Model. It is used to determine an appropriate rate of return of an asset. It’s a mathematical model that seeks to explain the relationship between risk and return in a rational equilibrium market.
William Sharpe, John Lintner and Jan Mossin independently developed the CAPM. The main element of this concept is that it separates the risk affecting an asset’s return into two categories. The first type is unsystematic or company specific risk. The long-term average returns for this kind of risk should be zero. The second kind of risk is called systematic risk, is due to general economic uncertainty. The CAPM states that the return on assets should on an average, equal the yield on a risk-free bond held over that time plus a premium proportional to the amount of systematic risk the stock possesses.
A fundamental principle of modern portfolio theory is that unsystematic risk can be mitigated through diversification. That is by holding many different assets, random fluctuations in the value of one will be offset by opposite fluctuations in another.
Systematic risk is a risk that cannot be removed by diversification. This risk represents the variation in an asset’s value caused by unpredictable economic movements. This type of risk represents the necessary risk that owners of a firm must accept when launching an enterprise. Regardless of product quality or executive ability, a firm’s profitability will be influenced by economic trends.
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