Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) Definition

Capital Asset Pricing Model (CAPM) is a measure of the relationship between the expected return and the risk of investing in security. This model is used to analyze securities and pricing them given the expected rate of return and cost of capital involved.

Capital Asset Pricing Model (CAPM)

CAPM Formula

The (capital asset pricing model) CAPM formula is represented as below

Expected Rate of Return = Risk-Free Premium + Beta * (Market Risk Premium)

Ra = Rrf + βa * (Rm – Rrf)

Components of CAPM

capital asset pricing model - capm v1

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Capital Asset Pricing Model (CAPM) (wallstreetmojo.com)

The CAPM calculation works on the existence of the following elements

#1 – Risk-free return (Rrf)

Risk-Free Rate of ReturnRisk-Free Rate Of ReturnA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more is the value assigned to an investment that guarantees a return with zero risks. Investments in US securities are considered to have zero risks since there is a minimal chance of the government defaulting. Generally, the value of the risk-free return is equivalent to the yield on a 10-year US government bond.

#2 – Market Risk Premium (Rm – Rrf)

Market Risk PremiumMarket Risk PremiumThe market risk premium is the supplementary return on the portfolio because of the additional risk involved in the portfolio; essentially, the market risk premium is the premium return investors should have to make sure to invest in stock instead of risk-free securities.read more is the expected return an investor receives (or expects to receive in the future) from holding a risk-laden portfolio instead of risk-free assets. The premium rate allows the investor to make a decision on if the investment in the securities should take place, and if yes, the rate that he will earn beyond the risk-free return offered by government securities.

#3 – Beta (βa)

The BetaBetaBeta is a financial metric that determines how sensitive a stock's price is to changes in the market price (index). It's used to analyze the systematic risks associated with a specific investment. In statistics, beta is the slope of a line that can be calculated by regressing stock returns against market returns.read more is a measure of the volatility of a stock with respect to the market in general. The fluctuations that will be caused in the stock due to a change in market conditions is denoted by Beta. For example, if the Beta of a stock is 1.2, it would cause a 120% change due to any change in the general market. The opposite is the case for Beta less than 1. For Beta, which is equal to 1, the stock is in sync with the changes in the market.

Examples of CAPM (Capital Asset Pricing Model)

The following are examples of CAPM (capital asset pricing model)

You can download this Capital Asset Pricing Model (CAPM) Excel Template here – Capital Asset Pricing Model (CAPM) Excel Template

Example #1

Suppose a stock has the following information. It is listed on the London stock exchange and operates throughout Europe. The yield on a UK 10 year treasury is 2.8%. The stock in question is supposed to earn 8.6% as per historical data. The Beta for the stock is 1.4, i.e., it is 140% volatile to the changes in the general stock market.

The expected rate of return of the stock will be calculated as below.

Capital Asset Pricing Model (CAPM) Example 1

CAPM Formula (Expected return) = Risk free return (2.8%) + Beta (1.4) * Market risk premium (8.6%-2.8%)

  • = 2.8 + 1.4*(5.8)
  • = 2.8 + 8.12

Expected Rate of Return = 10.92

Example #2

Thomas has to make a decision to invest in either Stock Marvel or Stock DC using the CAPM model illustrated by the following screenshot from the working. Thomas has to decide to either invest in Stock Marvel or Stock DC with the given information available to him. Marvel – Return 9.6%, Beta 0.95. DC – Return 8.7%, Beta 1.2. A risk-free return in the market, as measured by the return on government stock, is 5.6%.

The expected rate of return of the stock marvel will be calculated as below.

expected rate of return of the stock marvel

Formula – Expected return = Risk free return (5.60%) + Beta (95.00) * Market risk premium (9.60%-5.60%)

Expected Rate of Return = 9.40%

The expected rate of return of the stock DC will be calculated as below.

expected rate of return

Formula – Expected return = Risk free return (5.6%) + Beta (1.2) * Market risk premium (8.7%-5.6%)

Expected Rate of Return = 9.32%

Thus, the investor should invest in Stock Marvel.

Advantages of CAPM

Disadvantages of CAPM

  • The capital asset pricing model is hinged on various assumptions. One of the assumptions is that a riskier asset will yield a higher return. Next, the historical data is used to calculate Beta. The model also assumes that past performance is a good measure of the future results of a stock’s functioning. However, that is far from the truth.
  • The model also assumes that the risk-free return will remain constant over the course of the stock investment. If the return on the government treasury securities rises or falls, it will change the risk-free return and potentially the calculation of the model. It is not taken into account while calculating the CAPM
  • The model assumes that the investors have access to the same information and have the same decision-making process with respect to the risks and returns associated with the securities. It assumes that for a given return, the investors will prefer low-risk securities to high-risk securities. For a given risk, the investors will prefer higher returns to lower returns. Although this is a general guideline, some of the more extravagant investors might not be in agreement with this theory.

Limitations of the Capital Asset Pricing Model

Apart from the assumptions directly related to the factors around the stock and the capital asset pricing model calculation formula, there is a list of general assumptions that the model takes, which are worth looking into.

Conclusion

CAPM is widely regarded as one of the foremost models for calculating the risk and returns associated with investing in stocks. Although it utilizes a few assumptions, the rationale behind the model and the ease of use makes it one of the accepted and logical ways to help investors in their decision making.

Capital Asset Pricing Model (CAPM) Video

 

Recommended Articles

This article has been a guide to what is Capital Asset Pricing Model (CAPM) & its definition. Here we discuss the formula of CAPM to calculate CAPM along with practical examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

Reader Interactions

Comments

  1. Lisa Wu says

    Thanks! A very detailed and well explained article about CAPM.

    • Dheeraj Vaidya says

      Thanks for your kind words!