Answers the Question
How much interest should I demand for a given level of risk?
Calculator for CAPM
What Is the CAPM?
High interest rates can be very tempting for investors eager to earn high returns. It's not enough to look at how much is being offered, however. One must also consider the risk of each investment.
In general, the higher the risk of an investment, the greater the return that must be promised.
Fortunately, the CAPM (capital asset pricing model) lets people figure out whether the offered rate makes up for the lessened safety of many offerings.
It uses three variables:
- Risk free rate of return - The income that can be received without taking on any risk at all.
- Return on market - The income that can be received from the investment being examined. The greater the risk, the higher this value must be.
- Beta - The riskiness of the investment being evaluated.
Why Is it Important?
- Without a method of adjusting returns for risk, it can be impossible to determine whether an investment is worth making.
Formula(s) to Calculate CAPM
- RISK FREE RATE OF RETURN + BETA * ( RETURN ON MARKET - RISK FREE RATE OF RETURN )
- Assuming that all risks are well understood. In truth, many risks are either unknown, or misinterpreted. This formula is only as useful as the date that it uses.