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The capital asset pricing model (CAPM) calculates the expected return of an asset based on its sensitivity to market risk (beta) and the expected risk-free rate of return and return of the overall market. It assumes assets with higher risk should generate higher returns. The CAPM formula is still widely used despite limitations as it provides an easy way to compare investment alternatives and understand portfolio risk.

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Uday Bansal
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35 views3 pages

Reading Material

The capital asset pricing model (CAPM) calculates the expected return of an asset based on its sensitivity to market risk (beta) and the expected risk-free rate of return and return of the overall market. It assumes assets with higher risk should generate higher returns. The CAPM formula is still widely used despite limitations as it provides an easy way to compare investment alternatives and understand portfolio risk.

Uploaded by

Uday Bansal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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What is CAPM?

• The capital asset pricing model - or CAPM - is a


financial model that calculates the expected rate of
return for an asset or investment.
• CAPM does this by using the expected return on
both the market and a risk-free asset, and the asset's
correlation or sensitivity to the market (beta).
• There are some limitations to the CAPM, such as
making unrealistic assumptions and relying on a linear
interpretation of risk vs. return.
• Despite its issues, the CAPM formula is still
widely used because it is simple and allows for easy
comparisons of investment alternatives.
• For instance, it is used in conjunction with
modern portfolio theory (MPT) to understand portfolio
risk and expected return.
Understanding the Capital Asset Pricing
Model (CAPM)

The formula for calculating the expected


return of an asset, given its risk, is as follows:

ERi=Rf+βi(ERm−Rf)
where:
ERi=expected return of investment
Rf=risk-free rate
βi=beta of the investment
(ERm−Rf)=market risk premium

Investors expect to be compensated for risk


and the time value of money. The risk-free
rate in the CAPM formula accounts for the
time value of money. The other components
of the CAPM formula account for the investor
taking on additional risk.

The goal of the CAPM formula is to evaluate


whether a stock is fairly valued when its risk
and the time value of money are compared
with its expected return. In other words, by
knowing the individual parts of the CAPM, it
is possible to gauge whether the current price
of a stock is consistent with its likely return.
CAPM Example
For example, imagine an investor is contemplating a
stock valued at $100 per share today that pays a 3%
annual dividend. Say that this stock has a beta compared
with the market of 1.3, which means it is more volatile
than a broad market portfolio (i.e., the S&P 500 index).
Also, assume that the risk-free rate is 3% and this
investor expects the market to rise in value by 8% per
year.

The expected return of the stock based on the CAPM


formula is 9.5%:

5%=3%+1.3×(8%−3%)

The expected return of the CAPM formula is used to


discount the expected dividends and capital appreciation
of the stock over the expected holding period. If the
discounted value of those future cash flows is equal to
$100, then the CAPM formula indicates the stock is fairly
valued relative to risk.

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