The Capital Asset Pricing Model (CAPM) is a model that investors use to determine the rate of return of an investment. The model describes the relationship between the expected return of an investment and its risks. Furthermore, CAPM is one of the most commonly used models in finance for pricing risky stocks. Both investors and businesses use the model to calculate their rate of return.
For investors, CAPM can help with the calculation of the required rate of return. More importantly, it can help them develop a diversified portfolio of investments. For companies and businesses, CAPM helps with the calculation of the cost of equity. They can use the cost of equity in different processes such as investment appraisal or in the calculation of Weighted Average Cost of Capital (WACC).
Capital Asset Pricing Formula
To calculate the rate of return using CAPM investors and businesses use the following formula.
E(r)i = Rf + βi (E(r)m – Rf)
In the above formula, ‘E(r)i’ represents the expected rate of return of an investment or stock. ‘Rf‘ signifies the risk-free rate of return prevalent in the market. ‘βi’ represents the beta of the investment. Finally, ‘E(r)m‘ denotes the average rate of return in the market. Together, (E(r)m – Rf) represents the market risk premium.
Risk-free rate of return
The risk-free rate of return is the rate of return of a risk-free investment. Usually, it represents a theoretical rate of return and is close to the rate of return of short-term government treasury bills. For most calculations, investors can use the rate of return on those treasury bills instead of calculating the risk-free rate of return.
The most important part of the CAPM model is the Beta factor or coefficient of an investment. Beta represents the systematic risk of an investment. Systematic risk is the risk that applies to the market as a whole and not to a specific company or stock. Usually, companies with a beta of above 1 are riskier than the market. A beta of lower than 1 represents a lower risk than the market.
Market risk premium
The market risk premium of an investment represents the premium above the risk-free rate of return in the market. It is calculated by deducting the risk-free rate of return from the average market rate of return. In simpler words, the market risk premium is the difference between the average market rate of return and the risk-free rate of return.
Advantages of using CAPM
There are many advantages to using CAPM. First of all, it is easy to use. All the figures required in its calculations are available in the market. Similarly, the model is also useful because it takes into account the systematic risk of investments or stocks. Through these, CAPM allows investors to diversify their portfolio and eliminate unsystematic risk.
Disadvantages of using CAPM
There are also some disadvantages to using CAPM. These disadvantages come from the assumptions made by the model or its dependencies. First of all, CAPM assumes there is a risk-free rate of return, which is not possible. Similarly, for some investments calculating beta may not be possible. Therefore, it may limit the model.
The Capital Asset Pricing model can help investors determine the required rate of return of an investment. It is useful for both investors and businesses. To calculate the rate of return, investors must use the CAPM formula given above.