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Capital asset pricing model

The capital asset pricing model (or CAPM, as it is universally known) estimates the expected return for a firm’s stock. The calculation uses the prevailing risk-free rate, the stock’s trading history and the return that investors are expecting from owning shares.

When to use it

  • To estimate the price you should pay for a security, such as a share in a company.
  • To understand the trade-off between risk and return for an investor.

Origins

CAPM was developed by William Sharpe. In 1960, Sharpe introduced himself to Harry Markowitz, inventor of ‘modern portfolio theory’ (see Chapter 48), in search of a doctoral dissertation topic. Sharpe decided to investigate portfolio theory, and this led him to a novel way of ...

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