Capital Asset Pricing Model (CAPM)

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

In this type of risk, the cash flow of the company may affect from specific factors such as labour strikes, system failure and war etc.
By holding diversified investment by the investors , the unsystematic risk might be diversified away. However, systematic risk is not.

Formula of CAPM

Ke = Rf + [Rm – Rf] * Beta

Where

Ke = Cost of equity

Rf = Risk-free rate of return

Rm = Return on market portfolio

Example

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.

Why it Matters

Capital asset pricing model (CAPM) is used to decide what price one should pay for a particular stock. It gives a required rate of return for a given risk if we can estimate the risk level associated with a particular project or stock then we can use CAPM to give required rate (cost of equity) of to shareholders. After calculating the cost of equity by adjusting systematic risk, it is used to derive the weighted average cost of capital.
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