Capital Asset Pricing Model
(CAPM)
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Background/History of CAPM
Capital Asset Pricing Model (CAPM) was presented by Sharpe in year
1964
The Capital Asset Pricing Model (CAPM) describes the relationship
between systematic risk and expected return for assets, particularly stocks.
In simple, this model tells us what should be the expected rate of return
when an investor invests in stock market
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RF= It is the rate of return which RM= It is the expected return which you can
a person can get by depositing get if you invest in the market portfolio.
amount into the bank. It is
considered as risk free investment
Ke = It is called
the required Ke = RF + (RM – RF)i
rate of return
or expected
rate of return i = It is a measure of systematic risk for individual security. It
means how much a share of a company is impacted by systematic
risk. For example, “Alpha Textile Industry” use imported raw
material (cotton) to manufacture garment. The share price of
“Alpha Textile Company” will be more impacted by exchange rate
risk. On the other side, “Super Sugar Company” which use locally
produced raw material (Sugarcane) will be less impacted by
change in exchange rate
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Background/History of CAPM
Note:
The Beta of Overall market is always considered as “1”
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Background/History of CAPM
Suppose the risk free rate is 7 percent and expected market
return is 11 percent. The value of Beta of “Savance Company” is
1.20. Calculate the required rate of return on “Savance
Company” under Capital Asset Pricing Model
(CAPM)
RF = 7% or 0.07; RM = 11% or 0.11; = 1.20 Ke = ?
Ke = RF + (RM – RF)i
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Suppose the risk free rate is 7 percent and expected market return is 11 percent. The value
of Beta of “Savance Company” is 1.20. Calculate the required rate of return on “Savance
Company” under Capital Asset Pricing Model
(CAPM)
RF = 7% or 0.07; RM = 11% or 0.11; = 1.20 Ke = ?
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i
Ke = 0.07 + (0.11 – 0.07)1.20
Ke = 0.07 + (0.04)1.20
Ke = 0.07 + 0.048
Ke = 0.118
Ke = 11.8%
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Suppose the risk free rate is 7 percent and expected market return is 11 percent. The value
of Beta of “Savance Company” is 1.20. Calculate the required rate of return on “Savance
Company” under Capital Asset Pricing Model
(CAPM)
RF = 7% or 0.07; RM = 11% or 0.11; = 1.20 Ke = ?
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i Interpretation = If the Beta of Savance
Ke = 0.07 + (0.11 – 0.07)1.20 Company is 1.20 and risk free rate is 7
Ke = 0.07 + (0.04)1.20 percent than the required rate of return
Ke = 0.07 + 0.048 under CAPM should be 11.8%
Ke = 0.118
Ke = 11.8%
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Stock A
RF = 6% or 0.06; RM = 10% or 0.10; = 0.70
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i
Ke = 0.06 + (0.10 – 0.06)0.70
Ke = 0.06 + (0.04)0.70
Ke = 0.06 + 0.028
Ke = 0.088
Ke = 8.8%
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Stock A
RF = 6% or 0.06; RM = 10% or 0.10; = 0.70
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i Interpretation = If the Beta of Stock A is
Ke = 0.06 + (0.10 – 0.06)0.70 0.70 and risk free rate is 6 percent than the
required rate of return under CAPM
Ke = 0.06 + (0.04)0.70 should be 8.8%. Stock A provide less
Ke = 0.06 + 0.028 return as compared to market because its
Beta is less than market (Stock A Beta is
Ke = 0.088
0.70 as compared to the market Beta of 1)
Ke = 8.8%
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Stock B
RF = 6% or 0.06; RM = 10% or 0.10; =1
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i
Ke = 0.06 + (0.10 – 0.06)1
Ke = 0.06 + (0.04)1
Ke = 0.06 + 0.04
Ke = 0.10
Ke = 10%
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Stock B
RF = 6% or 0.06; RM = 10% or 0.10; =1
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i Interpretation = If the Beta of Stock B is
Ke = 0.06 + (0.10 – 0.06)1 1 and risk free rate is 6 percent than the
required rate of return under CAPM
Ke = 0.06 + (0.04)1 should be 10%. Stock B provide same
Ke = 0.06 + 0.04 return as market because its Beta is same
Ke = 0.10 as of market (Stock B Beta is 1 which is
also equal to the market Beta of 1)
Ke = 10%
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Stock C
RF = 6% or 0.06; RM = 10% or 0.10; = 1.15
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i
Ke = 0.06 + (0.10 – 0.06)1.15
Ke = 0.06 + (0.04)1.15
Ke = 0.06 + 0.046
Ke = 0.106
Ke = 10.6%
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Stock C
RF = 6% or 0.06; RM = 10% or 0.10; = 1.15
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i Interpretation = If the Beta of Stock C is
Ke = 0.06 + (0.10 – 0.06)1.15 1.15 and risk free rate is 6 percent than the
required rate of return under CAPM
Ke = 0.06 + (0.04)1.15 should be 10.6%. Stock C provide more
Ke = 0.06 + 0.046 return as compared to the market because
its Beta is more as compared to market
Ke = 0.106
(Stock C Beta is 1.15 which is greater
Ke = 10.6% than market Beta of 1)
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Stock D
RF = 6% or 0.06; RM = 10% or 0.10; = 1.40
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i
Ke = 0.06 + (0.10 – 0.06)1.40
Ke = 0.06 + (0.04)1.40
Ke = 0.06 + 0.056
Ke = 0.116
Ke = 11.6%
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Stock D
RF = 6% or 0.06; RM = 10% or 0.10; = 1.40
Ke = RF + (RM – RF)i
Ke = RF + (RM – RF)i Interpretation = If the Beta of Stock D is
Ke = 0.06 + (0.10 – 0.06)1.40 1.40 and risk free rate is 6 percent than the
required rate of return under CAPM
Ke = 0.06 + (0.04)1.40 should be 11.6%. Stock D provide more
Ke = 0.06 + 0.056 return as compared to the market because
its Beta is more as compared to market
Ke = 0.116
(Stock D Beta is 1.40 which is greater
Ke = 11.6% than market Beta of 1)
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