Capital asset pricing model (CAPM)
The capital asset pricing model is an equation to show the relation between investment return and the risk of the investment for a given tenure (or a single period, without any incremental investments).
How to calculate returns under CAPM Model?
E(r)= Rf+ (Rm-Rf)*B
E(r) is the expected returns on the asset, expressed as a percentage, for a given tenure
Rf is the minimum risk-free interest rate/returns of absolutely risk-free security for the same tenure as the investment under question, in a no-inflation scenario. Truly risk-free security is a government-issued bond, carrying a sovereign guarantee, with a fixed rate of interest.
Rm is the broader market returns
B is the beta or risk factor of the asset
How does CAPM Model work?
CAPM is used to estimate returns from securities which are riskier than, say, sovereign bonds of absolute risk-free nature. Hence, in effect, the returns, too, would be higher than on the risk-free option. (Rm-Rf)*B shows by how much our chosen security will give returns above the prevalent risk-free instrument’s returns, being part of the larger volatile market. Beta is factored in as it is the systematic risk of the security, as part of the larger volatile market (subject to market forces).
What are CAPM assumptions?
- Market is perfect
- Investors are risk-averse
- There is no transaction cost
- Investors have homogeneous expectations
- Lending & borrowing can be done risk-free rate of interest
- No inflation exists in the market
- Beta is the only measure of risk
The CAPM model is criticized for its assumptions. It is more of a theoretical representation of financial markets.