The Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH) are closely related concepts in finance that both address how securities are priced and how market efficiency influences asset returns.

Efficient Market Hypothesis (EMH):

EMH asserts that financial markets are “informationally efficient,” meaning that all available information is already reflected in stock prices. As a result, it is impossible to consistently achieve higher returns than the market average without taking on additional risk.

• EMH is typically categorized into three forms: weak, semi-strong, and strong, depending on the type of information reflected in stock prices.

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Capital Asset Pricing Model (CAPM):

CAPM is a model used to determine the expected return on an asset, given its risk relative to the market. It calculates the expected return based on the risk-free rate, the asset’s beta (which measures its sensitivity to market movements), and the expected market return.

CAPM Formula

The Capital Asset Pricing Model (CAPM) formula is:

E(R_i) = R_f + β_i (E(R_m) – R_f)

where:

• E(R_i) denotes the expected return on the asset,
• R_f is the risk-free rate,
• β_i is the asset’s beta (which measures its sensitivity to market movements), and
• E(R_m) is the expected market return.

Read more about Capital Asset Pricing Model (CAPM).

Relationship Between CAPM and EMH:

1. CAPM relies on the assumption that markets are efficient (consistent with the EMH). It assumes that all investors have access to the same information and that prices reflect all available information.
2. The model is built on the premise that the market portfolio, which represents a broad cross-section of all available assets, is efficient. In an efficient market, the CAPM provides a framework to understand the relationship between risk and return.
3. Both concepts suggest that it is difficult to outperform the market consistently, as prices adjust quickly to new information, aligning with the notion that higher returns are only achievable with higher risk.

In essence, CAPM uses the concept of market efficiency as a foundational assumption, while EMH supports the idea that CAPM’s predictions about expected returns and market behavior are based on realistic assumptions about market efficiency.