The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk.

**CAPITAL ASSET PRICING MODEL **(**CAPM**)

The capital
asset pricing model (CAPM) is used in finance to determine a theoretically
appropriate rate of return of an asset, if that asset is to be added to an
already well-diversified portfolio, given that asset's non-diversifiable risk.
The CAPM formula takes into account the asset's sensitivity to
non-diversifiable risk (also known as systematic risk or market risk), referred
to as beta (â) in the financial industry, as well as the expected return of the
market and the expected return of a theoretical risk-free asset. The model was
introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin
independently, building on the earlier work of Harry Markowitz on
diversification and modern portfolio theory.

**Formula**

The CAPM is
a model for pricing an individual security or a portfolio. The security market
line (SML) and its relation to expected return and systematic risk (beta) show
how the market must price individual securities in relation to their security
risk class. It enables to calculate the reward-to-risk ratio for any security
in relation to the overall market s. 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:

Individual
security s = Market s securities (portfolio) Reward-to-risk ratio
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), the Capital Asset Pricing Model
(CAPM) is obtained.

Where:

is the expected return on the capital asset is the risk-free rate
of interest

(the *beta
coefficient*) 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).

Asset pricing

Once the expected return, *E*(*Ri*)-,
is calculated using CAPM, the future

cash flows
of the asset can be discounted to their present value using this rate (*E*(*Ri*)-),
to establish the correct price for the asset.

In theory, therefore, an asset is
correctly priced when its observed price

is the same
as its value calculated using the CAPM derived discount rate. If the observed
price is higher than the valuation, then the asset is overvalued

**Asset-specific required
return**

The CAPM
returns the asset-appropriate required return or discount rate - i.e. the rate
at which future cash flows produced by the asset should be discounted given
that asset's relative risk. Betas exceeding one signify more than average
"risk"; betas below one indicate lower than average. Thus a more
risky stock will have a higher beta and will be discounted at a higher rate;
less sensitive stocks will have lower betas and be discounted at a lower rate.

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Business Science : Security Analysis and Portfolio Management : Portfolio Analysis : Capital Asset Pricing Model (CAPM) |

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