Capital asset pricing model: Difference between revisions
imported>Doug Williamson m (Spacing) |
imported>Doug Williamson (Added "theoretical" to references to risk-free rate. Added internal reference to risk-free rate of return.) |
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(CAPM). | (CAPM). | ||
The model links the expected rates of return on traded assets with their relative levels of market risk (beta). | The capital asset pricing model links the expected rates of return on traded assets with their relative levels of market risk (beta). | ||
The model’s uses include estimating a firm’s market cost of equity from its beta and the prevailing market risk-free rate of return. | |||
The model’s uses include estimating a firm’s market cost of equity from its beta and the prevailing theoretical market risk-free rate of return. | |||
The CAPM assumes a straight-line relationship between the beta of a traded asset and the expected rate of return on the asset. | The CAPM assumes a straight-line relationship between the beta of a traded asset and the expected rate of return on the asset. | ||
Expressed as a formula: | Expressed as a formula: | ||
Ke = Rf + beta x [Rm-Rf] | Ke = Rf + beta x [Rm-Rf] | ||
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Ke = cost of equity. | Ke = cost of equity. | ||
Rf = risk free rate of return. | |||
Rf = theoretical [[risk free rate of return]]. | |||
Beta = relative market risk. | Beta = relative market risk. | ||
Rm = average expected rate of return on the market. | Rm = average expected rate of return on the market. | ||
For example where: | For example where: | ||
Rf = risk free rate of return = 4%; | |||
Rf = theoretical risk free rate of return = 4%; | |||
Beta = relative market risk = 1.2; and | Beta = relative market risk = 1.2; and | ||
Rm = average expected rate of return on the market = 9%. | Rm = average expected rate of return on the market = 9%. | ||
Ke = 4% + 1.2 x [9% - 4% = 5%] | Ke = 4% + 1.2 x [9% - 4% = 5%] | ||
= <u>10%.</u> | = <u>10%.</u> | ||
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Under the capital asset pricing model only the (undiversifiable) market risk of securities is rewarded with additional returns, because the model assumes that rational market participants have all fully diversified away all specific risk within their investment portfolios. | Under the capital asset pricing model only the (undiversifiable) market risk of securities is rewarded with additional returns, because the model assumes that rational market participants have all fully diversified away all specific risk within their investment portfolios. | ||
== See also == | == See also == | ||
Revision as of 12:01, 12 August 2013
(CAPM).
The capital asset pricing model links the expected rates of return on traded assets with their relative levels of market risk (beta).
The model’s uses include estimating a firm’s market cost of equity from its beta and the prevailing theoretical market risk-free rate of return.
The CAPM assumes a straight-line relationship between the beta of a traded asset and the expected rate of return on the asset.
Expressed as a formula:
Ke = Rf + beta x [Rm-Rf]
Where:
Ke = cost of equity.
Rf = theoretical risk free rate of return.
Beta = relative market risk.
Rm = average expected rate of return on the market.
For example where:
Rf = theoretical risk free rate of return = 4%;
Beta = relative market risk = 1.2; and
Rm = average expected rate of return on the market = 9%.
Ke = 4% + 1.2 x [9% - 4% = 5%]
= 10%.
This investment requires an expected rate of return of 10%, higher than average rate of return on the market as a whole of only 9%, because its market risk (measured by Beta = 1.2) is greater than the average market risk of only 1.0.
Under the capital asset pricing model only the (undiversifiable) market risk of securities is rewarded with additional returns, because the model assumes that rational market participants have all fully diversified away all specific risk within their investment portfolios.
