What is Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a model that indicates the relationship between return and risk of the asset and also provides a framework to determine the required rate of return on an asset. The required rate of return stated by CAPM assists in valuing an asset. With the help of CAPM one can also compare the expected (estimated) rate of return on an asset with its required rate of return and determine whether the asset is fairly valued.

The capital asset pricing model offers a method for calculating a security’s expected return based on its risk level. The risk free rate plus beta times the difference between the demand and the risk free rate is the formula for the capital asset pricing model.

The CAPM formula

(ERm – Rf) = The market risk premium, which is calculated by subtracting the risk-free rate from the expected return of the investment account. The benefits of CAPM include the following: Ease of use and understanding.

The CAPM formula is used to calculate an asset’s projected returns. It is founded on the principle that investors should be compensated for systemic risk (also known as non-diversifiable risk) by paying a risk premium. A risk premium is an increase in the rate of return over the risk-free rate. When it comes to investing, more risky investments attract a higher risk premium.

Expected Profit in CAPM stands for Capital Asset Pricing Model

Given all of the other variables in the equation, the “Ra” notation represents the estimated return on a capital asset over time. The word “expected return” refers to a long-term prediction of how an investment will perform over the course of its entire existence.

Rate of Return without Risk in CAPM stands for Capital Asset Pricing Model

The risk-free rate, which is usually equivalent to the yield on a 10-year US government bond, is denoted by the letter “Rrf.” The risk-free rate should be appropriate for the country in which the investment is being made, and the bond’s maturity should conform to the investment’s time horizon.

The beta (abbreviated as “Ba” in the CAPM formula) is a calculation of a stock’s risk (volatility of returns) based on how its price fluctuates in comparison to the overall market. To put it another way, it refers to the stock’s vulnerability to market risk. If a company’s beta is 1.5, for example, its protection has 150 percent the volatility of the market average.

We can simplify the CAPM formula by reducing “expected return of the market minus the risk-free rate” to simply “market risk premium” using the above components. The market risk premium is the extra return needed to reward investors for investing in a riskier asset class over and above the risk-free rate.

In the finance sector, the CAPM formula is commonly used. Since CAPM calculates the cost of equity, it is critical in measuring the weighted average cost of capital (WACC).

In financial modelling, WACC is widely used. It can be used to measure the net present value (NPV) of an investment’s potential cash flows, as well as its enterprise value and equity value.

Why is CAPM important?

For a few specific reasons, the capital asset pricing model is critical in financial modelling. For starters, by assisting investors in calculating the anticipated return on an investment, it helps in determining the suitability of a specific investment.

What are the assumptions of CAPM?

The CAPM is based on the assumptions mentioned below.

It is useful for investors who are averse to take risks Investors are risk averse by nature, and diversification is needed to mitigate their risks. Rather than maximising wealth or return, an investor seeks to maximise the utility of his assets. The expression ‘utility’ refers to the variety of personal interests. Each increment of wealth is enjoyed less than the previous since each increment is less important in meeting the individual’s basic needs. Those with rising marginal utility for capital are among the investors who prefer higher risks. Each increase in wealth encourages the person to accumulate more wealth.

The primary idea behind CAPM is that a buyer of a risky asset should be compensated by the risk he/she is taking. This compensation is done through two ways –

The Risk and Time value of money. The time value of money is defined by the risk-free return that the investor could get if the same amount of money is invested in a risk-free security, like government bonds, over the same period of time for which he/she is investing in a risky asset.

Here, risk is measured by an element called beta which is the extra amount of money that the investor could get for taking on additional risks.

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