Capital asset pricing model: Difference between revisions
imported>Doug Williamson (Change 'Corporate_finance' to 'Equity' under See also, to make the links work.) |
imported>Doug Williamson (Standardise appearance of page) |
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Expressed as a formula: | Expressed as a formula: | ||
Re = Rf + beta x | Re = Rf + beta x ( Rm - Rf ) | ||
Where: | |||
Re = return on security. | Re = return on security. | ||
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'''Example''' | |||
Rf = theoretical risk free rate of return = 4% | Rf = theoretical risk free rate of return = 4%. | ||
Beta = relative market risk = 1.2 | Beta = relative market risk = 1.2. | ||
Rm = average expected rate of return on the market = 9%. | Rm = average expected rate of return on the market = 9%. | ||
Re = 4 | Return on security (Re): | ||
= 4 + 1.2 x ( 9 - 4 ) | |||
= | = 10%. | ||
This investment requires an expected <u>rate of return</u> of 10%, higher than average rate of return on the market as a whole of only 9%, because its market <u>risk</u> (measured by Beta = 1.2) is greater than the average market risk of only 1.0. | This investment requires an expected <u>rate of return</u> of 10%, higher than average rate of return on the market as a whole of only 9%, because its market <u>risk</u> (measured by Beta = 1.2) is greater than the average market risk of only 1.0. | ||
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When the CAPM is used to calculate an estimate of the cost of equity, it is conventionally expressed as: | When the CAPM is used to calculate an estimate of the cost of equity, it is conventionally expressed as: | ||
Ke = Rf + beta x | Ke = Rf + beta x ( Rm - Rf ) | ||
Where: | |||
Ke = cost of equity. | Ke = cost of equity. | ||
Revision as of 17:13, 18 March 2015
(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:
Re = Rf + beta x ( Rm - Rf )
Where:
Re = return on security.
Rf = theoretical risk free rate of return.
Beta = relative market risk.
Rm = average expected rate of return on the market.
Example
Rf = theoretical risk free rate of return = 4%.
Beta = relative market risk = 1.2.
Rm = average expected rate of return on the market = 9%.
Return on security (Re):
= 4 + 1.2 x ( 9 - 4 )
= 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.
Use of the CAPM to quantify cost of equity
When the CAPM is used to calculate an estimate of the cost of equity, it is conventionally expressed as:
Ke = Rf + beta x ( Rm - Rf )
Where:
Ke = cost of equity.
