Capital Asset Pricing Model(CAPM)

Posted in Finance, Accounting and Economics Terms, Total Reads: 1927
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Definition: Capital Asset Pricing Model(CAPM)

Developed by William Sharpe (1964) and John Lintner(1965), the theory establishes a relationship between risk and expected returns of a security and is  used to price risky securities.

In mathematical terms, it can be written as:

Where,

E(Ri)= Expected returns from the security

bi= systematic risk

E(Rm)= expected returns on market portfolio

Rf=risk free rate for a security having the same maturity as the security in concern

 

The essential features of the CAPM model are:

  1. It assumes that the market is made up of rational investors who have completely eliminated their unsystematic risk by diversification and hence should be compensated only for the market (or systematic) risk.
  2. Systematic risk is denoted by beta for a particular security and its components are shown in the formula. Beta has a range between -1 and 1 and usually around 0.3 to 0.7. Positive beta indicates that stock is positively correlated to the market whereas negative beta denotes that it is negatively correlated.
  3. An investor’s return should consider 2 components: time value of money and the inherent systematic risk of the security. The time value part is handled by Rf which is the risk free rate (obtained by T-bills, etc) on a similar maturity security when invested. The systematic risk part is handled by offering the investor a premium over the risk free rate which is denoted by the second part of the RHS of the CAPM equation.
  4. The CAPM model is useful in pricing risky securities and determining interest rates. If the return offered on a security is less than the CAPM model return, then the investor should invest in that security.
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