What is CAPM?
Capital Asset Pricing Model (CAPM) is used to derive the cost of equity or the security based on the risk perception of the investor. Two types of risk that make the risk perception are:
1- Systematic Risk
The risk in which, general macroeconomic factors (like interest rates, unemployment, and tax etc.) may affect the company’s cash flow in future.
2- Unsystematic Risk
Formula of CAPM
Ke = Rf + [Rm – Rf] * Beta
Ke = Cost of equity
Rf = Risk-free rate of return
Rm = Return on market portfolio
If the risk-free rate is 3%, the expected market return is 8%, the beta of the stock is 1.5 and the stock is expected to return 10.5% = 3%+[8%-3%] * 1.5
- The beta factor is usually used from a calculation of the third party.
- The risk-free rate (Rf) is used as a proxy from country’s treasury bills or bonds.
The Beta Factor
The CAPM model measures the systematic risk by using beta factor. Which is the measure of shares’ volatility in terms of market risk.
The beta factor of the whole market is 1 and there are four categories of beta factor
|Beta > 1||The shares have more systematic risk than the market.|
|Beta = 1||The shares have same systematic risk than the market.|
|Beta < 1||The shares have less systematic risk than the market.|
|Beta = 0||There is no risk to purchase shares.|