What is Capital Asset Pricing Model?

What is Capital Asset Pricing Model?

The Capital Asset Pricing Model (CAPM) is one of the key models used for calculating the return of securities. CAPM primarily involves a risk-free rate, expected market returns and market beta to develop the security pricing. A critical aspect of CAPM is the concept of undervalued and overvalued securities. If the rate of return is greater than the expected return, it would be considered an overvalued security. If the rate of return is less than expected returns, it would be regarded as undervalued security.

Example 

$ E(R_{i})=R_{F}+\left [ E(R_{M})-R_{F} \right ]\beta _{i} $

Where,
$ E(R_{i}) $ is the calculated return
$ R_{F} $ is the Risk-Free Rate
$ E(R_{M}) $ is the expected market return and
$ \beta _{i} $ is the market Beta

Numerical Example:

Let’s use the Capital Asset Pricing Model (CAPM) formula to calculate the expected return on a stock. Assume we have the following information about a stock:

Its operations are based in the United States, and it trades on the New York Stock Exchange. The current yield on a 10-year Treasury bill in the United States is 4.5 per cent. The average excess annual return on US stocks has been 8.5 per cent. The stock’s beta is 1.25. (Meaning its average return is 1.25x as volatile as the S&P500 over the last two years)

Using the CAPM formula, what is the expected return on the security?

What is the expected return of the security using the CAPM formula?

Let’s break down the answer using the formula from above in the article:

Expected return = Risk-Free Rate + [Beta x Market Return Premium]
Expected return = 4.5% + [1.25 x 8.5%]
Expected return = 15.125%

Why is it important to know about it?

CAPM forms the foundation of investment analysis, which includes investment risk management – one of the essential areas of Risk Management.