Term Report                                                                                                   Corporate Finance                                                                                                                            

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically appropriate required  (and thus the price if expected cash flows can be estimated) of an , if that asset is to be added to an already well-diversified , given that asset's non- risk. The CAPM formula takes into account the asset's sensitivity to non-diversifiable  (also known as  or ), often represented by the quantity  (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical  asset

The Formula

The CAPM is a model for pricing an individual security (asset) or a portfolio. For individual security perspective, we made use of the  (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

Individual security’ / beta        =       Market’s securities (portfolio)

Reward-to-risk ratio                          Reward-to-risk ratio

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for (Ri), we obtain the Capital Asset Pricing Model (CAPM).

Where:

  • Ri - is the expected return on the capital asset
  • Rf - is the risk-free rate of interest
  • β - (the ) the  of the asset returns to market returns, or also ,
  • Rm - is the expected return of the market
  • (Rm – Rf) -  is sometimes known as the market premium or risk premium.

Assumptions of CAPM

  • All investors have rational expectations.
  • There are no arbitrage opportunities.
  • Returns are distributed normally.
  • Fixed quantity of assets.
  • Perfectly efficient capital markets.
  • Investors are solely concerned with level and uncertainty of future wealth
  • Separation of financial and production sectors.
  • Thus, production plans are fixed.
  • Risk-free rates exist with limitless borrowing capacity and universal access.
  • The Risk-free borrowing and lending rates are equal.
  • No inflation and no change in the level of interest rate exists.
  • Perfect information, hence all investors have the same expectations about security returns for any given time period.

CAPM is the theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk Premium.

Expected Risk Premium=Beta X Market Risk Premium

Ri   =   beta x (Rm – Rf)

Where

Ri is the risk-adjusted discount rate (also known as the Cost of Capital);
Rf is the rate of a "risk-free" investment.
Rm is the return rate of a market benchmark.

The CAPM assumes that the Stock market is dominated by well diversified investors who are concerned only with market risk. That makes sense in a stock market where trading is dominated by large institutions and even small investor can diversify at very low cost. The Security Market Line shows that how expected rate of return depends upon Beta. According to CAPM, expected rates of return for all securities and all portfolios lie on this line.

Beta

The Beta coefficient, in terms of  and , is a measure of a stock (or )’s  in relation to the rest of the market. Beta is calculated for individual companies using regression analysis.

Join now!

The beta coefficient is a key parameter in the  (CAPM). It measures the part of the asset's statistical  that cannot be mitigated by the  provided by the portfolio of many risky assets, because it is  with the return of the other assets that are in the portfolio.

The Formula for the Beta of an asset within a portfolio is  

βA = Cov(ra,rp) / Var (rp)

Where ra measures the rate of return of the asset, rp measures the rate of return of the portfolio of which the asset is a part and Cov(ra,rp) is the covariance between the rates of return. In the CAPM ...

This is a preview of the whole essay