Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a foundational financial theory used to assess the expected or average return on an investment. The model is predicated on the principle that the expected return on an asset is determined by its inherent risk, captured by the asset’s beta coefficient, in conjunction with the risk-free rate of return and a risk premium. The CAPM is formally expressed as:

\[ E(R_i) = R_f + \beta_i (E(R_m) - R_f) \]

Where:

• \( E(R_i) \): Expected return on asset or portfolio \( i \)
• \( R_f \): Risk-free rate of return
• \( \beta_i \): Beta coefficient of the asset or portfolio \( i \)
• \( E(R_m) \): Expected return on the market portfolio

Examples

1. Example 1: Estimating Return
   Suppose the risk-free rate \( R_f \) is 3%, the expected market return \( E(R_m) \) is 8%, and a stock has a beta coefficient \( \beta \) of 1.5. Using CAPM, the expected return \( E(R_i) \) for the stock is:

   \[ E(R_i) = 3% + 1.5 \cdot (8% - 3%) = 10.5% \]

2. Example 2: Portfolio Analysis
   For a portfolio with a beta of 0.8, a risk-free rate of 2%, and an expected market return of 9%, the expected return would be:

   \[ E(R_i) = 2% + 0.8 \cdot (9% - 2%) = 7.6% \]

Frequently Asked Questions (FAQs)

Q1: What is the significance of the beta coefficient in CAPM?

• A: The beta coefficient measures the sensitivity of an asset’s return relative to the market return. It indicates how much the asset’s return is expected to change with a 1% change in the market return.

Q2: Can CAPM be used for both stocks and bonds?

• A: Yes, CAPM can be used to determine the expected return for any security, including stocks and bonds, by taking into account their respective betas.

Q3: What is the risk-free rate in CAPM?

• A: The risk-free rate usually refers to the return on government bonds, such as U.S. Treasury bills, which are considered free from default risk.

Q4: How does CAPM assist in NPV calculations?

• A: The expected return calculated using CAPM is often used as the discount rate in net present value (NPV) calculations, helping to assess the present value of future cash flows.

Q5: Is CAPM applicable in all market conditions?

• A: While widely used, CAPM has limitations and may not always accurately reflect returns, especially in markets experiencing significant volatility or where risk-free rates and market returns are abnormal.

Related Terms

• Risk-Free Rate of Return: The return on an investment with zero risk, often represented by government bonds.
• Risk Premium: The additional return over the risk-free rate required by investors to compensate for the risk of an investment.
• Beta Coefficient: A measure of the volatility or systematic risk of an asset in comparison to the market as a whole.
• Net Present Value (NPV): The difference between the present value of cash inflows and outflows over a period of time.

Online References

• Investopedia
• Khan Academy - Finance and Capital Markets

Suggested Books for Further Studies

• “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen: A comprehensive guide to corporate finance principles, including CAPM.
• “Investment Valuation: Tools and Techniques for Determining the Value of Any Asset” by Aswath Damodaran: Detailed examination of investment valuation techniques, including CAPM application.
• “Corporate Finance” by Jonathan Berk and Peter DeMarzo: An in-depth resource covering CAPM and its implications in corporate finance.

Accounting Basics: “CAPM” Fundamentals Quiz

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