Capital Asset Pricing Model (CAPM) | Understanding Risk & Reward In The Stock Market
Being an investor, you must have come across several financial models that help you assess your investment. One such tool is the capital asset pricing model ( CAPM ) that we will be discussing in this article delight. It is a powerful tool that helps investors to understand the relationship between risk and reward in the stock market. By using it, investors can calculate investment risk and expected return. So, let’s buckle up and take a closer look at this important concept of CAPM.
What is Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) estimates the expected return on an investment given its systematic risk. CAPM is a theory that helps investors determine how much return they can expect to earn on a particular investment based on the level of risk involved. It suggests that the expected return on investment should be higher if it’s considered riskier and lower if it’s considered safer. For example, investing in stocks is generally considered riskier than investing in bonds, so stocks are expected to have a higher return than bonds.
Key Terminology in CAPM
let’s get familiar with some of the key terminologies that form the backbone of this concept.
1. Risk-free Rate: This refers to the theoretical rate of return of an investment that carries no risk, typically represented by government bonds. It is the minimum return an investor should expect from any investment that carries no risk of losing money.
2. Market Risk Premium: This is the excess return an investor expects to receive from investing in a risky asset over and above the risk-free rate of return. It represents the additional compensation required by an investor for taking on market risk.
3. Beta: Beta is a measure of the volatility or systematic risk of an asset relative to the overall market. It measures how an asset’s price is likely to move relative to changes in the overall market. A beta of 1 indicates that an asset moves in line with the market, while a beta of less than 1 indicates that it is less volatile than the market, and a beta of greater than 1 indicates that it is more volatile than the market.
4. Expected Return: The expected return is the return an investor expects to receive from an investment over a particular period. You calculate that by multiplying the investor’s required rate of return by the asset’s beta.
5. Required Rate of Return: The required rate of return is the minimum return an investor expects to receive for investing in a particular asset. You calculate that by adding the risk-free rate of return to the market risk premium, and then multiplying this sum by the asset’s beta.
Capital Asset Pricing Model (CAPM) Formula Explained | A practical approach in Understanding Risk & Reward In The Stock Market
The CAPM formula helps investors calculate the expected return of a security by factoring in the risk-free return and a risk premium.
So, the formula for the expected return (ER) on a security is:
Expected return (ER) = Risk-free rate (RFR) + Beta (β) x (Market return (MR) – Risk-free rate (RFR))
The CAPM formula has three important components that investors should know.
Expected return (ER) is the return that an investor expects to receive on a particular asset.The risk-free rate (RFR) is the return that an investor can earn on a safe and secure investment, such as a government bond. The market return (MR) is the return that investors can expect to earn on a comparable market index, such as the Nifty 50 or Sensex.The difference between the market return and the risk-free rate is known as the risk premium, which is also referred to as the market risk premium.
While estimating market returns can vary according to asset class, investors can use historical data from popular indices such as the Nifty 50 or Sensex to calculate the market return. By understanding these key terms, investors can use the CAPM formula to determine the expected return of an asset.
Example of Capital Asset Pricing Model (CAPM)
To calculate the expected return, you first need to determine the risk-free rate of return, which is the return on an investment with zero risk. This you usually by the yield on government bonds, which are considered to be virtually risk-free in India. Let’s say the current yield on a 10-year government bond is 6%.
Next, you need to determine the expected return of the market, which you can estimate using a market index like the BSE Sensex or the Nifty 50. Let’s say the expected return of the market is 12%.
The next step is to calculate the beta of the stock in question. Beta measures the volatility of a stock compared to the market. Let’s say the beta of the stock is 1.5.
Now that you have all the inputs, you can use the CAPM formula to calculate the expected return of the stock:
Expected return (ER) = Risk-free rate (RFR) + Beta (β) x (Market return (MR) – Risk-free rate (RFR))
So, Expected return = 6% + 1.5 x (12% – 6%)
Expected return = 15%
The calculated expected return of 15% is the return an investor should expect from the stock based on its risk level.
How to determine whether a stock is undervalued or overvalued with CAPM ?
You can also use CAPM formula to determine valuation of a stock. If the actual return of the stock is lower than 15%, it could be considered undervalued and a good investment opportunity. If the actual return is higher than 15%, the stock may be overvalued and not a good investment opportunity.
To know more about valuation of a stock, visit https://corporatefinanceinstitute.com/resources/valuation/stock-valuation/
Drawbacks of relying solely on CAPM
Assumptions may not hold
CAPM relies on certain assumptions, such as the efficient market hypothesis, which may not always hold true in real-world scenarios. Therefore, the model may not be an accurate representation of the market and may lead to poor investment decisions.
Limited in scope
CAPM only takes into account market risk and assumes that all investors have access to the same information. This means that it may not fully capture other factors that can impact the value of an investment.
Relies on historical data
CAPM relies on historical data to estimate market risk and return, which may not always be a reliable predictor of future performance.
Final Takeaway
The simplicity and accuracy of Capital Asset Pricing Model (CAPM) make it an appealing choice for investors, but it’s crucial to recognize that no model is perfect. While CAPM is a valuable financial model that has transformed the way we think about risk and return, it’s essential to understand both its advantages and limitations. Investors must use CAPM in conjunction with other tools and analyses, such as fundamental analysis and technical analysis, to make informed investment decisions.
Read also : Cashflow Committed vs Networth Committed Mindset | Which One Suits You Better ?https://thebrightdelights.com/cashflow-committed-vs-networth-committed-mindset-which-one-suits-you-better/