What is the ‘Capital Asset Pricing Model – CAPM’
The capital asset pricing model (CAPM) is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating costs of capital.
BREAKING DOWN ‘Capital Asset Pricing Model – CAPM’
The formula for calculating the expected return of an asset given its risk is as follows:
The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The risk-free rate is customarily the yield on government bonds like U.S. Treasuries.
The other half of the CAPM formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf): the return of the market in excess of the risk-free rate. Beta reflects how risky an asset is compared to overall market risk and is a function of the volatility of the asset and the market as well as the correlation between the two. For stocks, the market is usually represented as the S&P 500 but can be represented by more robust indexes as well.
The CAPM model says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).
Example of Capital Asset Pricing Model (CAPM)
Using the CAPM model and the following assumptions, we can compute the expected return for a stock:
The risk-free rate is 2% and the beta (risk measure) of a stock is 2. The expected market return over the period is 10%, so that means that the market risk premium is 8% (10% – 2%) after subtracting the risk-free rate from the expected market return. Plugging in the preceding values into the CAPM formula above, we get an expected return of 18% for the stock:
18% = 2% + 2 x (10%-2%)