The Capital Asset Pricing Model (CAPM) for Beginners

The capital asset pricing model (CAPM) is one of the fundamental cornerstones to beginning finance education for investments. Pronounced ("CAP"-"M"), it is an academic pricing model that is also used by high ranking professional investment companies. Like every other academic financial concept the capital asset pricing model has an emphasis on future expectations of the investment. Therefore, there is quite a bit of reflective predicting which does not fare well at all during times of cyclical shifts and times of market turbulence.

The formula

The asset pricing model has a very basic formula that is extremely intuitive for beginners to understand. However, the most difficult part of the formula is not the calculating but rather coming to a reasonable consensus on plugging the proper values for the variables within the formula. Because of the variables used, all of the formula's variables have values that are not one hundred percent accurate, but can be reasonable estimations.

CAPM Expected Return= Risk-free rate + (Beta*MRP)

Where the expected return for the investment (asset) is the risk free rate plus the beta value multiplied by the market risk premium (MRP).

Risk-free rate

Given there exists many different risk free rates, the value will be ranging a little bit depending on the method used to derive the risk-free rate. The easiest way to derive the risk-free rate is to quote the rate on the 10-year treasury and use that as a proxy.

One other method which is more accurate is to look at the 30 day treasury bill futures rates with about a year until expiration. This will derive the annual risk-free rate which has almost no default risk unlike the 10-year treasury.

Beta

The beta value is a factor of sensitivity or volatility of the asset compared to the broader market. Where the broader market has a beta factor of 1, the asset may have a negative value or positive value greater or less than 1. If greater than one the investment is more volatile than the broader market. To calculate the beta variable, you need a history of weekly or monthly investment returns compared to broader market returns during the same historical time period.

The beta measures how compared to the broader market does the investment move in tandem. Keep in mind, a stock with a negative correlation to the broader market will have negative investment returns during positive market returns, and vice-versa.

Market risk premium

This is by far the hardest variable to calculate because it requires the prediction of the return of the broader market. Obviously, if we knew the market and it's future rate of return we wouldn't need the asset pricing model at all. Theoretically, the actual value of the market expected return is not extremely important, however the number computed for MRP is the most important variable in the capital asset pricing model. With the assumption that we can use an average of the analyst's predictions for the broader market, which is available in Barron's newspapers and the Financial Times, the market risk premium is simply the expected return of the market minus the risk free rate.

Theoretically

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