How is risk measured in CAPM?

The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between the expected return of an asset and its risk. Risk is measured in CAPM using beta, which is a measure of the volatility of an asset’s returns relative to the volatility of the market as a whole.

Beta is calculated by dividing the covariance of an asset’s returns with the covariance of the market’s returns. A beta of 1 indicates that an asset’s returns are perfectly correlated with the market’s returns. A beta of more than 1 indicates that an asset’s returns are more volatile than the market’s returns. A beta of less than 1 indicates that an asset’s returns are less volatile than the market’s returns.

Beta is an important measure of risk because it can be used to estimate the expected return of an asset. The CAPM states that the expected return of an asset is equal to the risk-free rate plus a risk premium that is proportional to the asset’s beta.

The risk-free rate is the return that an investor can expect to earn on a risk-free investment, such as a Treasury bill. The risk premium is the additional return that an investor requires to compensate them for taking on risk.

The CAPM can be used to estimate the expected return of an asset by using the following formula:

Expected return = Risk-free rate + Beta * Risk premium

For example, if the risk-free rate is 2% and the risk premium is 5%, then the expected return of an asset with a beta of 1 would be 7%.

Beta is a useful measure of risk, but it is important to note that it is not the only measure of risk. Other measures of risk include standard deviation, variance, and value at risk (VaR).