What is Capital Asset Pricing Model (CAPM) Explained. Essentials of Investments. CPA Exam
In this video, I discuss capital asset pricing model (capm). The capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset.
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The capital asset pricing model was developed by the financial economist (and later, Nobel laureate in economics) William Sharpe, set out in his 1970 book Portfolio Theory and Capital Markets. His model starts with the idea that individual investment contains two types of risk:
Systematic Risk – These are market risks—that is, general perils of investing—that cannot be diversified away. Interest rates, recessions, and wars are examples of systematic risks.
Unsystematic Risk – Also known as "specific risk," this risk relates to individual stocks. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves.
Modern portfolio theory shows that specific risk can be removed or at least mitigated through diversification of a portfolio. The trouble is that diversification still does not solve the problem of systematic risk; even a portfolio holding all the shares in the stock market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk is what most plagues investors.
The CAPM Formula
CAPM evolved as a way to measure this systematic risk. Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost of capital. The standard formula remains the CAPM, which describes the relationship between risk and expected return.
CAPM's starting point is the risk-free rate–typically a 10-year government bond yield. A premium is added, one that equity investors demand as compensation for the extra risk they accrue. This equity market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta."
Beta's Role in CAPM
According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative volatility–that is, it shows how much the price of a particular stock jumps up and down compared with how much the entire stock market jumps up and down. If a share price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10% and fall by 15% if the market fell by 10%.
Beta is found by statistical analysis of individual, daily share price returns in comparison with the market's daily returns over precisely the same period. In their classic 1972 study "The Capital Asset Pricing Model: Some Empirical Tests," financial economists Fischer Black, Michael C. Jensen, and Myron Scholes confirmed a linear relationship between the financial returns of stock portfolios and their betas. They studied the price movements of the stocks on the New York Stock Exchange between 1931 and 1965.
Beta, compared with the equity risk premium, shows the amount of compensation equity investors need for taking on additional risk. If the stock's beta is 2.0, the risk-free rate is 3%, and the market rate of return is 7%, the market's excess return is 4% (7% - 3%). Accordingly, the stock's excess return is 8% (2 x 4%, multiplying market return by the beta), and the stock's total required return is 11% (8% + 3%, the stock's excess return plus the risk-free rate).
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