The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security. Below is a graphic explaining the CAPM concept.
CAPM Formula and Calculation
CAPM is calculated according to the following formula:
Ri = Rf+ ßi * ( Rm – Rf )
- Ri represents the expected return of a capital asset over time, given all of the other variables in the equation. “Expected return” is a long-term assumption about how an investment will play out over its entire life.,
- Rf is the risk free rate, which is typically equal to the yield on a 10-year US government bond. The risk-free rate should correspond to the country where the investment is being made, and the maturity of the bond should match the time horizon of the investment. Professional convention, however, is to typically use the 10-year rate no matter what, because it’s the most heavily quoted and most liquid bond.
- Rm is the expected return of the market. From the above components of CAPM, (Rm – Rf) can also be reduced to to be simply the “market risk premium”. The market risk premium represents the additional return over and above the risk-free rate, which is required to compensate investors for investing in a riskier asset class. Put another way, the more volatile a market or an asset class is, the higher the market risk premium will be.
- ßi is the beta of the security/subject company/business and is a measure of a stock’s risk (volatility of returns) reflected by measuring the fluctuation of its price changes relative to the overall market. In other words, it is the stock’s sensitivity to market risk. For instance, if a company’s beta is equal to 1.5 the security has 150% of the volatility of the market average. However, if the beta is equal to 1, the expected return on a security is equal to the average market return. A beta of -1 means security has a perfect negative correlation with the market.