Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the Capital Asset Pricing Model (CAPM) estimate?

1. Optimal asset allocation

2. Expected return on a security

3. Entire market return

4. Risk assessment of a portfolio

The correct answer is: Expected return on a security

The Capital Asset Pricing Model (CAPM) is fundamentally designed to estimate the expected return on a security based on its systematic risk, measured by beta. It operates on the premise that investors require additional return as compensation for the risk they assume by investing in a security over a risk-free rate. According to CAPM, the expected return is derived from the risk-free rate plus a risk premium, which is the product of the security’s beta (a measure of its volatility or systematic risk compared to the market as a whole) and the market risk premium (the expected return of the market minus the risk-free rate). This formula helps investors assess whether a security is fairly valued given its risk compared to the overall market. The focus of CAPM on the relationship between risk and expected return makes it particularly useful for investors who are evaluating individual securities within the context of their portfolios. While optimal asset allocation, entire market return, and risk assessment are important concepts in portfolio management, they do not directly describe the specific function of CAPM, which is to provide an estimation of the expected return on a particular security given its risk profile.