Portfolio Management - The Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is a model that calculates expected return based on expected rate of return on the market, the risk-free rate and the beta coefficient of the stock.



Formula 17.11

E(R) = Rf + ß( Rmarket - Rf )




Example: CAPM model
Determine the expected return on Newco's stock using the capital asset pricing model. Newco's beta is 1.2. Assume the expected return on the market is 12% and the risk-free rate is 4%.

Answer:
E(R) = 4% + 1.2(12% - 4%) = 13.6%.

Using the capital asset pricing model, the expected return on Newco's stock is 13.6%.


The Security Market Line (SML)
Similar to the CML, the SML is derived from the CAPM, solving for expected return. However, the level of risk used is the Beta, the slope of the SML.

The SML is illustrated below:




Beta
Beta
is the measure of a stock's sensitivity of returns to changes in the market. It is a measure of systematic risk.


Formula 17.12



Beta = B = Covariance of stock to the market
Variance of the market




Example: Beta
Assume the covariance between Newco's stock and the market is 0.001 and the variance of the market is 0.0008. What is the beta of Newco's stock?

Answer:

BNewco = 0.001/0.0008 = 1.25

Newco's beta is 1.25.


Determing Whether a Security is Under-, Over- or Properly Valued
As discussed, the SML line can be derived using CAPM, solving for the expected return using beta as the measure of risk. Given that interpretation and a beta value for a specific security, we can then determine the expected return of the security with the CAPM. Then, using the expected return for a security derived from the CAPM, an investor can determine whether a security is undervalued, overvalued or properly valued.


Example:Calculate the expected return on a security and evaluate whether the security is undervalued, overvalued or properly valued.
An investor anticipates Newco's security will reach $30 by the end of one year. Newco's beta is 1.3. Assume the return on the market is expected to be 16% and the risk-free rate is 4%. Calculate the expected return of Newco's stock in one year and determine whether the stock is undervalued, overvalued or properly valued with a current value of $25.

Answer:

E(R)Newco = 4% + 1.3(16% - 4%) = 20%

Given the expected return of Newco's stock using CAPM is 20% and the investor anticipates a 20% return, the security would be properly valued.
  • If the expected return using the CAPM is higher than the investor's required return, the security is undervalued and the investor should buy it.
  • If the expected return using the CAPM is lower than the investor's required return, the security is overvalued and should be sold.


The Characteristic Line
The characteristic line is line that occurs when an individual asset or portfolio is regressed to the market. The beta is the slope coefficient for the characteristic line and is thus the measure of systematic risk for the asset or portfolio. Recall, a beta is the measure of a stock's sensitivity of returns to changes in the market. It is a measure of systematic risk.



Related Articles
  1. Fundamental Analysis

    The Capital Asset Pricing Model: An Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  2. Options & Futures

    Financial Concepts: Capital Asset Pricing Model (CAPM)

    Pronounced as though it were spelled "cap-m", this model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe. The capital ...
  3. Fundamental Analysis

    Capital Asset Pricing Model - CAPM

    CAPM is a model that describes the relationship between risk and expected return.
  4. Forex Education

    Reduce Your Risk With ICAPM

    Avoid unnecesary risks involved in CAPM calculations by also incorporating ICAPM into the mix.
  5. Investing Basics

    Introduction To International CAPM

    ICAPM is one of several models used to determine the required return on an asset, discover its limitations and how to use it.
  6. Fundamental Analysis

    Catch On To The CCAPM

    The consumption capital asset pricing model smoothes over some of CAPM's weaknesses to make sense of risk aversion.
  7. Fundamental Analysis

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  8. Stock Analysis

    Build Diversity Through Beta

    In conjunction with stock valuation ratios like the price-to-earnings ratio and the price-to-earnings-growth ratio, a stock's measure of volatility known as beta can help investors build a diversified ...
  9. Stock Analysis

    Build Diversity Through Beta

    In conjunction with stock valuation ratios like the price-to-earnings ratio and the price-to-earnings-growth ratio, a stock's measure of volatility known as beta can help investors build a diversified ...
  10. Term

    Evaluating Alpha and Beta

    Alpha and beta are risk ratios that investors use to calculate, compare and predict returns.
RELATED TERMS
  1. International Capital Asset Pricing ...

    A financial model that extends the concept of the capital asset ...
  2. Consumption Capital Asset Pricing ...

    A financial model that extends the concepts of the capital asset ...
  3. Characteristic Line

    A line formed using regression analysis that summarizes a particular ...
  4. Fama And French Three Factor Model

    A factor model that expands on the capital asset pricing model ...
  5. Volatility

    1. A statistical measure of the dispersion of returns for a given ...
  6. Anomaly

    A term describing the incidence when the actual result under ...
RELATED FAQS
  1. What is the formula for calculating the capital asset pricing model (CAPM)?

    Learn about the capital asset pricing model, or CAPM, and how this formula is used to determine the expected rate of return ... Read Answer >>
  2. How do I use the CAPM (capital asset pricing model) to determine the cost of equity?

    Learn about the elements of the capital asset pricing model, and discover how to use this formula to calculate a business' ... Read Answer >>
  3. How do I interpret a Security Market Line (SML) graph?

    Find out how to interpret stocks and portfolios through a security market line, or SML, graph as part of the Capital Asset ... Read Answer >>
  4. What types of risk are incorporated in Security Market Line (SML) analysis?

    Learn about security market line analysis, how it is used and how the beta and systematic risk of a stock affect an investment ... Read Answer >>
  5. How do I calculate the cost of equity using Excel?

    Learn how to calculate the cost of equity in Microsoft Excel using the capital asset pricing model, or CAPM, including brief ... Read Answer >>
  6. According to the CAPM, the expected return on a stock, that is part of a portfolio, ...

    A. the covariance between the stock and the market. B. the variance of the market. C. the market risk premium. D. ... Read Answer >>
Hot Definitions
  1. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  2. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  3. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  4. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  5. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  6. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
Trading Center