Explain the Capital Asset Pricing Model and its practical implications.

The Capital Asset Pricing Model (CAPM) is a foundational model in finance that explains the relationship between systematic risk and expected return for assets, particularly stocks. The CAPM is based on the following formula: \begin{equation}E[R_i] = R_f + \beta_i (E[R_m] - R_f) \end{equation} where $E[R_i]$ is the expected return of asset $i$. $R_f$ is the risk-free rate. $\beta_i$ is the sensitivity of the asset's returns to the market returns. $E[R_m]$ is the expected return of the market portfolio. $E[R_m] - R_f$ is the market risk premium. The Capital Asset Pricing Model (CAPM) illustrates the relationship between systematic risk and expected return of an asset. It posits that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. The risk premium is determined by the asset's beta, representing its volatility compared to the market. Practically, CAPM is used to estimate the appropriate required rate of return for an investment, considering its risk, and is fundamental in strategic asset allocation and portfolio management. The Fama-French three-factor and five-factor models expand upon CAPM by introducing additional factors to better capture the nuances of asset returns.

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Capital Asset Pricing Model (CAPM)

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