CAPM (Capital Assest Pricing Model)
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    • CAPM (Capital Assest Pricing Model)

    Harshit Gupta

    Bank of America Continuum India
    Cap-M" looks at risk and rates of return and compares them to the overall stock market. If you use CAPM you have to assume that most investors want to avoid risk, (risk averse), and those who do take risks, expect to be rewarded. It also assumes that investors are "price takers" who can't influence the price of assets or markets. With CAPM you assume that there are no transactional costs or taxation and assets and securities are divisible into small little packets. Had enough with the assumptions yet? One more. CAPM assumes that investors are not limited in their borrowing and lending under the risk free rate of interest. By now you likely have a healthy feeling of skepticism. We'll deal with that below, but first, let's work the CAPM formula -

    Rs = Rf + B ( Rm - Rf)

    where

    • Rs = The Required Rate of Return.
    • Rf = The Risk Free Rate of return
    • B = measure of vlatility or systematic risk of security
    • Rm = Market rate of return

    As an example, let's assume that the risk free rate is 5%, and the overall stock market will produce a rate of return of 12.5% next year. You see that ABC company has a beta of 1.7.

    What rate of return should you get from this company in order to be rewarded for the risk you are taking? Remember investing in ABC company (beta =1.7) is more risky than investing in the overall stock market (beta = 1.0). So you want to get more than 12.5%, right?

    • Rs = Rf + B ( Rm - Rf)
    • Rs = 5% + 1.7 ( 12.5% - 5%)
    • Rs = 5% + 1.7 ( 7.5%)
    • Rs = 5% + 12.75%
    • Rs = 17.75%

    So, if you invest in ABC Company, you should get at least 17.75% return from your investment. If you don't think that ABC Company will produce those kinds of returns for you, then you would probably consider investing in a different stock.
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