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What is the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a fundamental asset pricing model that helps determine the expected return on an investment based on its risk. Essentially, it explains the relationship between risk and return, emphasizing that higher risk should be compensated with higher potential returns.

CAPM is often used as an alternative method to estimate the cost of capital. It focuses specifically on systematic risk—the kind of risk that cannot be eliminated through diversification, as it is tied to overall market movements.

The model tells us that the expected return on a security equals the risk-free rate plus a risk premium, which depends on the security’s beta—a measure of how much it moves relative to the market. In simple terms, CAPM answers the critical investment question: "Given the market’s risk, how much return should I expect for investing in this particular security?

Breaking Down the 4 Key Components of CAPM

The Capital Asset Pricing Model (CAPM) has four key components that help investors understand the expected return from a security in relation to its risk. Let’s break them down:

1. Expected Return (ER):

This is the minimum return an investor expects to earn from a security. If the expected return doesn't meet or exceed this threshold, the investment may not be worth the risk.

2. Risk-Free Rate (Rf):

This represents the return on an investment with zero risk, typically associated with government securities like Treasury bonds or fixed deposits (FDs). Since the returns are fixed and guaranteed, there’s virtually no risk involved—making it the baseline for comparing riskier investments.

3. Beta (β):

Beta measures the sensitivity of a security to market movements—also known as systematic risk. A beta of 1.0 means the security moves in line with the market. If beta is greater than 1, the security is more volatile than the market; if it's less than 1, it's less volatile.

For example, if a stock has a beta of 1.5 and the market drops by 1%, the stock is expected to drop by 1.5%. Conversely, if the market rises by 1%, the stock might gain 1.5%. This makes beta a crucial indicator for understanding how responsive a security is to market fluctuations.

4. Market Risk Premium (ERm - Rf):

This is the additional return an investor expects for taking on market risk, calculated by subtracting the risk-free rate from the expected market return.

For instance, if the market is expected to return 8% and the risk-free rate is 5%, the market risk premium is:

Market Risk Premium = 8% - 5% = 3%

This 3% represents the extra reward investors demand for bearing additional risk compared to a risk-free investment.

The CAPM Formula (Putting It All Together)

Expected Return (R)=Rf + β(Rm − Rf )

Where:

R = Expected return of the asset

Rf = Risk-free rate (e.g., return on government bonds)

β (Beta) = Measure of the asset's risk compared to the market

Rm = Expected return of the market

(Rm - Rf) = Market risk premium

CAPM in Action: A Tesla Stock Example

Let’s say an investor is considering buying shares of Tesla (TSLA).

Assume:

Risk-free rate (Rf) = 3% (10-year U.S. Treasury yield)

Expected market return (Rm) = 10%

Tesla’s beta (β) = 1.8

Using CAPM:

E(TSLA) = 3% + 1.8 × (10% − 3%)

= 3% + 1.8 × 7%

= 3% + 12.6%

= 15.6%

Interpretation:

According to CAPM, an investor should expect a 15.6% return per year for taking on the risk of investing in Tesla, compared to a risk-free investment. If you believe Tesla will return more than 15.6%, it might be undervalued. If less, it could be overvalued.

About the Author: Abhishek Lohar

B.Com Graduate and the Founder of Free Online Financial Calculator. I specialize in simplifying complex financial calculations and investment strategies. My mission is to ensure you can make confident financial decisions using our research-backed content and accurate calculators.

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Disclaimer: The information provided in this article is for educational purposes only and should not be considered financial advice. Please consult with a qualified professional before making any investment decisions.