Capital Asset Pricing Model

 


Capital Asset Pricing Model 

The Capital Asset Pricing Model (CAPM) entails the relationship between the expected return and the risk of investing in security.  

This model is used to analyze securities and price them given the expected rate of return and cost of capital involved. 


CAPM Formula 


The (capital asset pricing model) CAPM formula is represented below 

Expected Rate of Return = Risk-Free Premium + Beta * (Market Risk Premium) 

Ra = Rrf + βa * (Rm – Rrf) 

 

Components of CAPM  CAPM – cost of equity 


Risk Free Rate –  


  • The return investor expects from a completely risk-free investment 

  • Should be in the currency cash low 


Beta 


  • The degree to which a company’s equity returns varies with the return of the overall market. 

  • Beta is a function of both the business risk as well as the financial risk 

  • Beta is a measure of systematic risk 


Risk Premium 


  • Investing in the stock market is riskier than investing in government bonds 

  • An Investor expects a higher return to induce them to take the higher risk of investing in equities 

 

Advantages of CAPM 


  • CAPM considers only the systematic or market risk or not the security’s only inherent or systemic risk. The model assumes that the investor holds a diversified portfolio, and hence the unsystematic risk is eliminated between the stock holdings. 

  • It is widely used in the finance industry to calculate the cost of equity and ultimately the weighted average cost of capital, which is used extensively to check the cost of financing from various sources.  


  • It is a universal and easy-to-use model. Given the extensive presence of this model, this can easily be utilized for comparisons between stocks of various countries. 

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