The Capital Asset Pricing Model, or CAPM, is one of the most commonly used models for calculating the expected return on an asset and is used to price securities.
The CAPM requires 3 data inputs:
- Beta of the asset (how much it moves relative to the market)
- Risk free rate (i.e. government bond yield)
- Expected return of the market (i.e. S&P return)
With all these figures, the calculation for the expected return is:
- Expected Return on Asset = Risk Free Rate + (Beta Asset x [Expected Market Return - Risk Free Rate])
For example, assume the following:
- Risk Free Rate = 2.5%
- Beta = 1.8
- Expected Market Return = 5%
The expected return on the asset is:
- 2.5 + 1.8 x (5 - 2.5) = 7%
The reasons behind using a model such as the CAPM is that investors need to be compensated for taking risk. The model says that for any level of risk (beta), the return needs to exceed the return of a risk-free asset by a certain amount and that the more risk is assumed, the higher return is required.
In the example above, the asset has a beta of 1.8 which is reasonably high. If a more stable industry such as a utility company is looked at, the required return is considerably lower.
- Risk Free Rate = 2.5%
- Beta = 0.6
- Expected Market Return = 5%
- Required Return = 2.5 + 0.6 x (5 - 2.5) = 4%
This is a much lower required return and most utility companies pay 4% or more in dividends alone.
Although the CAPM should never be used to as a stand-alone tool for determining where to invest money, it is extremely useful in working out if you are being over or under-compensated for the amount of risk you are taking, although clearly there are a lot of variables involved, some of which cannot really be predicted with a great degree of accuracy.
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