Measure the Trade-Off Between Risk and Return with the CAPM

The Capital Asset Pricing Model (CAPM) is used to determine the appropriate rate of return of an asset. In calculating this expected return, the CAPM accounts for both risk and the time value of money and can be used to assign a discount rate for the purpose of asset valuation. The idea behind the CAPM model is that since even well-diversified portfolios take on some level of risk, rational investors should expect to be compensated for that risk.

The formula for the CAPM can be written as:

Using the calculator below, the time value of money is represented by the available risk-free rate of return to provide compensation to the investor for putting money into an investment for some period of time. The additional risk
portion is represented by beta to compare the returns of the asset to overall market returns.

Generally speaking, the CAPM model says that if the expected return of the investment does not meet the investor’s required return, then the investment is not worthwhile.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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