Capital Asset Pricing Model [CAPM]

{ Posted on Oct 24 2008 by Ellen }
Categories : Investing Ideas, Learning, Money, Results

The CAPM is a model for pricing an individual security or a portfolio. For individual securities, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio. The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

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One Response to “Capital Asset Pricing Model [CAPM]”

  1. By johi on Nov 26, 2008 | Reply

    i mentiones here formula of CAPM
    so plz publish it

    The CAPM is a model for pricing an individual security or a portfolio. For individual securities, we made use of the security market line (SML) and its relation to expected return and systemic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:
    ,
    The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

    Where:

    is the expected return on the capital asset
    is the risk-free rate of interest such as interest arising from government bonds
    (the beta coefficient) is the sensitivity of the asset returns to market returns, or also ,
    is the expected return of the market
    is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return).

    Restated, in terms of risk premium, we find that:

    which states that the individual risk premium equals the market premium times beta.

    Note 1: the expected market rate of return is usually measured by looking at the arithmetic average of the historical returns on a market portfolio (i.e. S&P 500).
    Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return and not the current risk free rate of return

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