CAPITAL ASSET PRICING MODEL : and HOW WE UNDERSTAND IT BRIEFLY
Understanding the view of the investment theory will help us in so many ways including how we allocating the capital asset and facing the risk that might affect its return.
One of important investment theory is Capital Asset Pricing Model
According to Lakonishok and Shapiro (1984) Capital Asset Pricing Model is a model which expressed stock returns as a linear function of both beta and total risk (variance).
The simple one period Capital Asset Pricing Model (CAPM) developed by Sharpe and Lintner that has had enormous impact on the theory and practice of finance during the past decade.
The CAPM model showed that the required return on an assets equals to the risk-free rate of interest plus a risk premium that is proportional to the asset’s “beta” coefficient.
The risk-free rate accounts for time value of money, while the other components is actually account for how the investor taking an additional risks.
Breaking the theory :
ERi = Expected return of investment
Rf = Risk-free rate
βi = Beta of the investment
ERm = Expected return of market
(ERm – Rf) = Market risk premium
The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared to its expected return.
For example
An invenstor has a stock worth $200 per share and pays 2% dividend. But, the stock has a beta that comparing to the market is 1,2. Risk free rate is 3%. He expected the return would be 5%
The calculation would be like this :
ERi = 0.03 + 1.2 ( 0.05 – 0.03)
= 0.054
so the expected return would be 5,4%.
Based on the equation, we understand that the risk may recognized by the data. But, when visually define by graphic. There is Security Market Line (SML).
It reflected the required return in the marketplace for each level of nondiversifiable risk (beta). In the graph, a risk measured by beta, b is plotted on the x axis, and required returns, k are plotted on the y axis. The risk-return tradeoff is clearly represented by the SML.
Here are the graph :
Summary :
The CAPM model provides a useful conceptual framework for evaluating and linking risk and return. An awareness of this tradeoff and attempt to consider risk as well as return in financial decision making should help financial managers to achieve their goals.
Reference :
Gitman, Lawrence J., and Chad J. Zutter. Fourteenth Edition. Principles of Managerial Finance
https://www.investopedia.com/terms/c/capm.asp
Pamane and Vikpossi (2014). An Analysis of the Relationship between Risk and Expected Return in the BRVM Stock Exchange: Test of the CAPM. Research in World Economy.Vol 5. www.sciedu.ca/rwe
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Interesting article as prep material of midterm. Thanks.
because my article is about risk and return, CAPM is one of way to minimize risk and increase return, great article rin..
Good Article Rini. I can’t Believe CAPM so simple as that. I should read this article before the exam. but it’s too late.. thanks for sharing..