Capital Asset Pricing Model (CAPM) 🏛️📈
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. It is used to determine the "Fair Return" that an investor should expect for taking a certain level of market risk.
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1. The Core Idea
In a rational market, investors should not be rewarded for taking risk that can be diversified away (Unsystematic Risk). Therefore, the return of a stock should only depend on its Systematic Risk (Beta).
2. The CAPM Formula
The equation for the expected return of an asset is:
E(Ri) = Rf + Beta_i * (Rm - Rf)
Where:
- E(Ri): Expected return of the asset.
- Rf: Risk-Free Rate of return (e.g., Govt Bond yield).
- Beta_i: The asset's sensitivity to the market.
- Rm: The expected return of the market.
- (Rm - Rf): The Market Risk Premium (The extra return for choosing stocks over bonds).
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3. Interpreting CAPM
- Riskless Asset: If a stock has a Beta of 0, its return should be exactly Rf.
- Market-Like Asset: If a stock has a Beta of 1.0, its return should be exactly Rm.
- Aggressive Asset: If Beta > 1.0, the stock should provide a return higher than the market to compensate for the higher risk.
If a stock's actual return is higher than what CAPM predicts, the stock is "Underpriced" (A Bargain). If it's lower, the stock is "Overpriced."
4. Assumptions of CAPM
CAPM is built on several "perfect world" assumptions:
- Investors are rational and risk-averse.
- There are no transaction costs or taxes.
- All investors have the same expectations about the future.
- Investors can lend and borrow at the risk-free rate.
Summary
- CAPM link risk (Beta) and return.
- It ignores Unsystematic Risk because it can be diversified away.
- The Market Risk Premium is the engine that drives stock returns.
- It is the foundation of modern valuation and corporate finance.
Quiz Time! 🎯
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