CAPITAL ASSET PRICING MODEL

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Capital asset pricing model (CAPM) is a mathematical model that describes the expected returns received from an investment based on its riskiness relative to the rest of the market. It indicates that the expected return on a security is equal to the risk-free return plus the risk premium based on the security’s Beta. The mathematical representation of the CAPM is shown below:-
E Ri = Rs + ßi[E(Rm)-R]
Where,
ERi= market return
Rf= risk-free rate
ẞi=sensitivity
ERm= expected return of the market

CAPM has many advantages which have proved to be effective in making it better and also popular. Some of them are discussed below-

  • Easy to use: As CAPM is a simple calculation, it is easy to use and it derives more accurate possible outcome to provide confidence around the required rate of return.
  • Diversified portfolio: It considers only systematic risk. Investors having diversified portfolio, get rid of the unsystematic risk as it eliminates essentially.
  • Helps to invest: It provides high discount rates to use in investment appraisal.

Along with the advantages CAPM has its drawbacks also like other scientific models. Primary drawvacks are discussed below:-

  • Determination of Beta: In CAPM it is difficult to determine the beta. In this model determination of beta is very important for the investors as it reflects the security. If it fails to calculate an accurate beta value, it may cause investors to face losses.
  • Accurate representation of the market: Another drawback that occurs when you rely solely on CAPM is the model may not be an accurate representation of the market which may create difficulty for the investors in making good investment decisions.
  • Limited scope: The CAPM only takes into account market risk and assumes that all investors have the same information.

Understanding mathematical representation of CAPM with the help of example:
If banks gives you 4% returns instead of 0% risk, here 0% risk will be beta (ßi) and 4% returns will be risk free rate of market return (Rf). When you invest in stock market ,the beta i.e risk become 1%. Now, if stock market gives 5% or 6% returns instead of 1% beta value, you will not invest as it is not worth it. You will need a better rate of market return which can balance the risk. Therefore if you get 15% market return, now you will think of investing as the market return rate rises. Here 1% risk will be beta value (ßi) and 15% return will be the market return (ERi). But you were getting 4% return even without risk. By shifting from 0% risk to 1% risk, you get 11% (15%-4%) return. Basically, you get that extra 11% return because you took risk of 1% to invest in the stock market. If you had not taken that 1% risk, you would not have got that extra 11% market return. Therefore here 1% risk is beta value (ßi), 15% return is expected market return (ERm) and 11% is market return (ERi) for taking the 1% risk.

From the above explanation I hope you have understood the mathematical representation of CAPM. CAPM will help you in investment but your skills will be the reason for your loss or profit.

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2 thoughts on “CAPITAL ASSET PRICING MODEL

  1. Sekret-Natury

    Outstanding feature

  2. Odkryj jak

    Insightful piece

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