CAPM
Properties
Capital Asset Pricing Model (CAPM):
The capital asset pricing model (CAPM) describes the relationship between systematic risk, or the general perils of investing, and expected return for assets, particularly stocks. It is a finance model that establishes a linear relationship between the required return on an investment and risk.
CAPM is based on the relationship between an asset’s beta, the risk-free rate (typically the Treasury bill rate), and the equity risk premium, or the expected return on the market minus the risk-free rate.
# Definition
The CAPM formula is:
where:
- \(ER_i\) = Expected return of the investment
- \(R_f\) = Risk-free rate
- \(\beta_i\) = Beta of the investment
- \(ER_m\) = Expected return of the market
- \((ER_m - R_f)\) = Market risk premium
# CAPM Example
Capital Asset Pricing Model (CAPM):
Imagine an investor is contemplating a stock valued at $100 per share today that pays a 3% annual dividend. Say this stock has a beta compared with the market of 1.3, which means it is more volatile than a broad Market Portfolio (i.e., the S&P 500 Index). Also, assume that the risk-free rate is 3% and this investor expects the market to rise in value by 8% per year.
The expected return of the stock based on the CAPM formula is 9.5%:
$$ 9.5\% = 3\% + 1.3 \times (8\% - 3\%) $$
The expected return of the CAPM formula is used to discount the expected dividends and capital appreciation of the stock over the expected holding period. If the discounted value of those future cash flows is equal to $100, then the CAPM formula indicates the stock is fairly valued relative to risk.