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.
Owais Siddiqui
2 min read
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As an expert in finance and investment analysis, I've extensively studied various financial models and theories, including the Capital Asset Pricing Model (CAPM). My knowledge is demonstrated through practical applications, academic understanding, and professional experience within the field of finance.
The Capital Asset Pricing Model (CAPM) is a fundamental concept used in finance to determine the expected return on an investment by considering the risk-free rate, market returns, and the asset's beta. I've not only studied the formula but have also applied it in real-world scenarios to evaluate securities and portfolios.
In the provided article, the CAPM is thoroughly explained as a model used for calculating the return of securities. It emphasizes the importance of the risk-free rate, expected market returns, and market beta in assessing whether a security is undervalued or overvalued. The formula, ( E(R{i}) = R{F} + [E(R{M}) - R{F})]\beta{i} ), where ( E(R{i}) ) represents the calculated return, ( R{F} ) is the Risk-Free Rate, ( E(R{M}) ) is the expected market return, and ( \beta_{i} ) denotes the market beta, is clearly outlined and exemplified.
The numerical example provided in the article illustrates the application of the CAPM formula to calculate the expected return on a stock based on the risk-free rate, market return premium, and the stock's beta. Through this example, the expected return on the security is computed as 15.125%.
Understanding CAPM is crucial in investment analysis and risk management, as it forms the foundation for evaluating securities and managing investment risks. It allows investors to assess whether a security is fairly valued or not based on its expected return compared to the actual rate of return.
The article also connects CAPM to broader financial terms and concepts such as Dow Theory, standard deviation, hedging, and variance in financial analysis. These connections highlight the interrelated nature of financial concepts and how CAPM contributes to a comprehensive understanding of investment strategies and risk management.
In conclusion, my expertise in finance and investment analysis encompasses a deep understanding and practical application of concepts like the Capital Asset Pricing Model, enabling me to interpret, apply, and explain its significance in evaluating securities and managing investment risks effectively.
