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Guide To Capital Asset Pricing Model!

The Capital Asset Pricing Model (CAPM) is a tool developed in the 1960s to estimate expected investment returns based on market risk, using a formula that incorporates the risk-free rate, beta, and market risk premium. Beta measures an investment's volatility relative to the market, influencing expected returns, while CAPM is widely used by investors and companies for evaluating stock returns and funding decisions. However, CAPM has limitations, including assumptions of market efficiency and reliance on historical data for beta.

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12 views12 pages

Guide To Capital Asset Pricing Model!

The Capital Asset Pricing Model (CAPM) is a tool developed in the 1960s to estimate expected investment returns based on market risk, using a formula that incorporates the risk-free rate, beta, and market risk premium. Beta measures an investment's volatility relative to the market, influencing expected returns, while CAPM is widely used by investors and companies for evaluating stock returns and funding decisions. However, CAPM has limitations, including assumptions of market efficiency and reliance on historical data for beta.

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priyankapillaivlog
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Beginners Guide to

CAPITAL ASSET PRICING


MODEL (CAPM)
Ever wondered how much return you
should expect from an investment?

Knowing the potential return on your


investments is crucial whether you're a
seasoned investor or just starting out.

This is where the Capital Asset Pricing


Model (CAPM) comes into play.
CAPM was developed by William F.
Sharpe, John Lintner, and Jan Mossin in
the 1960s.

It is a tool used to determine how much


return you should expect from an
investment based on its market risk.
CAPM Formula

E(Ri) = Rf + βi + (Rm−Rf)

Where:

E(Ri) = Expected return of the


investment
Rf = Risk-free rate
βi= Beta of the investment
Rm = Expected return of the market
Rm−Rf= Market risk premium
Risk-Free Rate (Rf): This is the return on
an investment with zero risk, typically
government bonds. It represents the
minimum return investors expect for any
investment.

Beta (β): Beta measures an investment's


volatility compared to the market.

Beta > 1 = higher volatility

beta < 1 =lower volatility


Market Risk Premium (Rm - Rf):
Additional return investors expect from
the market over the risk-free rate.
A Simple Example to Understand
Imagine you are considering investing
in a stock with a beta of 1.2. The risk-free
rate is 3%, and the expected return of
the market is 8%.

Using the CAPM formula:

E(Ri)= 3% + 1.2 × (8%−3%)


E(Ri)= 3%+1.2 × 5%
E(Ri)= 3% + 6%
E(Ri)= 9%

The expected return on the stock,


according to CAPM, is 9%.
Capital Asset Pricing Model
(CAPM)
Let’s decode beta a bit more.
Beta = 1 means the stock moves like the
market

Beta = 0 means no market risk, so


expected return is equal to the risk-free
rate

Beta > 1 means more risk, so more


return expected

Beta < 1 means lower risk, so less return


expected
CAPM is useful in many ways
Investors use it to evaluate if a stock’s
return is justified.

Companies use it to calculate cost of


equity for funding decisions.

It’s also used in portfolio construction.


But CAPM also has flaws
It assumes that markets are efficient
and that all investors have the same
expectations.

Beta is based on historical data and


may not accurately predict volatility.

It considers only market risk, ignoring


other real-world factors.

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