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CAPM_Notes

Class Notes on CAPM

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9 views2 pages

CAPM_Notes

Class Notes on CAPM

Uploaded by

Gasimovsky
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Notes on Capital Asset Pricing Model

(CAPM) Calculation
1. Introduction to CAPM
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
expected return and risk of investing in a security. It is widely used to estimate the expected
return on an asset given its systematic risk measured by beta (β).

2. CAPM Formula
E(Rᵢ) = Rf + βᵢ (E(Rm) - Rf)

- E(Rᵢ): Expected return of the investment


- Rf: Risk-free rate
- βᵢ: Beta of the investment (sensitivity to market return)
- E(Rm): Expected return of the market
- E(Rm) - Rf: Market risk premium

3. Steps in CAPM Calculation


Step 1: Identify the risk-free rate (Rf)
- Usually the yield on long-term government bonds (e.g., 10-year U.S. Treasury Bonds).

Step 2: Estimate the expected market return (E(Rm))


- Can be based on historical returns of a broad market index like the S&P 500.

Step 3: Obtain the beta (β) for the security


- Measures how much the security's returns move relative to the market.
- Beta > 1: More volatile than market
- Beta < 1: Less volatile than market

Step 4: Plug the values into the CAPM formula to compute expected return.

4. Example
Assume:
- Rf = 3%
- E(Rm) = 10%
- β = 1.2
Then:
E(Rᵢ) = 3% + 1.2 × (10% - 3%) = 3% + 1.2 × 7% = 3% + 8.4% = 11.4%

So, the expected return is 11.4%.

5. Interpretation
The CAPM return represents the minimum required return an investor should expect, given
the risk. If the actual expected return exceeds this value, the investment may be considered
attractive.

6. Limitations of CAPM
- Assumes a single-period investment horizon.
- Beta assumes linear risk and market return relationship.
- Market returns and beta are based on historical data.
- Ignores other forms of risk (e.g., liquidity risk, business risk).

7. Conclusion
CAPM is a foundational tool in finance for pricing risky assets and understanding the trade-
off between risk and return. It’s essential for portfolio optimization, cost of equity
estimation, and capital budgeting.

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