CAPM is an excellent calculation model that investors around the world trust. However, there are some downsides to it.
- Rates that are risk-free tend to fluctuate frequently
- A risk-free rate is not realistic
- It can be difficult to determine a beta
The risk-free premium, or rate used for CAPM calculations, is generated by short-term government securities. This model has a major flaw: the risk-free rate can change in a matter of days.
Individual investors are not able to borrow or lend at the same rate as the government. It is impossible to assume a zero-risk rate of return for calculations. This means that the real return on investment could be lower than what the CAPM model shows.
This model of return calculation requires investors to calculate a beta value that reflects the security being invested in. It can be difficult and time-consuming to calculate an accurate beta value. In most cases, a proxy value for beta is used. This not only speeds up return calculations, but it also reduces their accuracy. Compared to other scientific models, a capital asset pricing model has similar problems. However, it still gives an accurate picture of what kind of dividends investors can expect if they place their money at risk.
CAPM Example
This example of CAPM can help you understand how the formula works. The following can be helpful in understanding the different factors involved in the calculation of CAPM.
Investors are considering stocks priced at Rs. 367 offer annual returns of 4.4%. If this stock has a beta factor of 1, one can calculate the expected dividend earnings using the risk-free premium of 3% and the investor expectation of market appreciation of 7% annually.
The formula can be arranged to produce the following conclusion:
Ra = 4% + 1.11 x (7%-3%%)
Ra = 8.4%
Another example of the CAPM model is this: This next example shows that the investor is ready to purchase stocks worth Rs. 455. These investments are expected to yield around 9% in annual returns. In this instance, the beta factor is 0.8. The risk-free rate is 5%. The investor anticipates that the market will increase in value by approximately 8% over the next year.
Ra = 9% + 0.8% x (8%-5%)
Ra = 11.4%
Beta's role in CAPM
CAPM incorporates beta. It reflects the volatility of given security against the volatility of the stock market as a whole. To understand this better, think about how a share's value increases and decreases in complete sync with the stock market. In this case, the beta factor would equal one.
If a stock's beta is 1.2, it indicates that stock prices will rise by 12% if the market appreciates 10%. A stock with a negative beta (e.g. 0.7), indicates that stock prices will increase by 7% when the overall market grows by 10%.
When determining how much compensation an investor will receive for taking on additional risk, it is necessary to add beta and calculate the risk premium.
