Quantitative investing
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 capital asset pricing model formula for calculating expected return is:
![The capital asset pricing model formula for calculating expected return is:](https://images.ctfassets.net/tl4x668xzide/647LTUWRvlqN0jzCIbvliG/8ae82bd457581a824160d6eb11abcd2b/capital-asset-pricing-model-800.jpg?fit=pad&w=800&h=315&f=center&fm=webp)
The Capital Asset Pricing Model 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 capital asset pricing model showed that the relationship between risk and return is less strong than the theory indicates.
* One of the first tests was a study performed by Haugen and Heins: ‘On the Evidence Supporting the Existence of Risk Premiums in the Capital Market’ (1972). They demonstrated that over the period 1929 - 1971, low-volatility equities realized extra risk-adjusted returns.