Understanding Capital Asset Pricing Model (CAPM)

Risk is an inherent part of any investment. CAPM helps the investor determine his expected returns in relation to the market.

If there was a way to predict exactly how much returns we would make on volatile investments like stocks, we would all be billionaires today! However, being able to predict the exact outcome of the market is as easy as being a sightseer; you’ll always have the upper hand because of the extra information you have.

This right here is the relationship between CAPM and Efficient Market Hypothesis (EMH), but we’ll get to that.

Capital Asset Pricing Model is a system that is used to calculate the predicted rate of return of any risky asset. It determines the fairest price for an investment, based on the risk, potential return and other factors.

Remember that there are two kinds of risks that affect any security – Systematic and Unsystematic risk. While unsystematic risk is typically tied to the industry you invest in and other variables that can be controlled and curbed through diversification of your portfolio, systematic risk cannot be controlled.

It is directly tied to the market information and is the reason for volatility of stock investments. What this means is that it doesn’t matter how much you diversify your investments, there will always be a risk element.

This is why investors would require a good enough rate of return that compensates them for the risk involved.

CAPM, thus, compares the relationship between systematic risk and expected rate of return. The rate of return is the increase in value you should expect to see based on the inherent risk level of the asset.

In essence, this allow you to effectively price riskier investments. What CAPM does is to establish a fair value of stock and it is a great way investors analyse the stock’s current market value allowing the investor tell whether a risky asset is worth investing in or not. You compare the fair value to the market price.

Where your price estimate is higher than the market's, that means you got it as a discount; however, where the computed value is lower than the market value, it means the stock is overvalued.

CAPM takes two things into account. It first takes reckon of the time value of money and them, it accounts for the assumed risk. To calculate CAPM, use the formula below:

ra = rrf + Ba (rm – rrf)

This is less complicated than it looks. The variables stand for:

– ‘ra’ refers to the required rate of return in an asset

– ‘rrf’ refers to the rate of return on a risk-free security (like treasury bills)

– ‘Ba’ is the beta of the asset (measure of investment risk)

– ‘rm’ is the market’s expected return

In our next post, we would breakdown the CAPM formula and how it can be used to your advantage as an investor.

Written by Lawretta Egba.