CAPM

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model - CAPM

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.



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(Levy, 2005). The other half of the 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 CAPM 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).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

The Capital Asset Pricing Model (CAPM)•Some, but not all, of the risk associated with a risky investment can be eliminated by diversification(Barlow, 2005). The reason is that unsystematic risks, which are unique to individual assets, tend to wash out in a large portfolio, but systematic risks, which affect all of the assets in a portfolio to some extent, do not.

Because unsystematic risk can be freely eliminated by diversification, the systematic risk principle states that the reward for bearing risk depends only on the level of systematic risk. The level of systematic risk in a particular asset, relative to average, is given by the beta of that asset.

The reward-to-risk ratio for Asset is the ratio of its risk premium, E(Ri) - Rf, to its beta, Bi:[E(Ri) - Rf]/Bi•In a well-functioning market, this ratio is the same for every asset. As a result, when asset expected returns are plotted against asset betas, all assets plot ...