Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model is a model that is used to calculate the expected rate of return on a particular asset. The return can be divided into two parts:

 

Expected Return= Risk Free Rate of Return + β (Market Risk Premium)

 

where, risk free rate of return denotes the minimum required return of a portfolio which contains any risk free asset (generally sovereign bonds). This is the time value of the investment since investments are discounted at this risk-free rate of return. β is the asset’s sensitivity to market returns,  and the  market risk premium is the return that the investor expects over the risk-free asset for investing in the market. The above equation can also be written as:

 

r_a = r_f + β_a (r_m-r_f)

 

Where,

r_f = risk free rate

r_m= market rate of return

β_a = beta of the security

 

In other words, ‘r_a’ is the reward (return) that the investor expects for taking the systematic risk in the market. The model also signifies that if the expected return does not meet or beat the required return, then the investment should not be undertaken.

 

Example

Assume the following for asset XYZ:

r_f = 3%

r_m = 10%

β_a = 0.75

 

By using CAPM, the rate of return in asset XYZ:

r_a = 0.03 + [0.75 * (0.10 - 0.03)]

0.0825 = 8.25%

 

If an investor wants a return of 10% for his investment, then as per CAPM model, he should not invest in XYZ. But, if the investor seeks a return less than 8.25%, say 7%, then it is better to invest in XYZ.