Running head: Capital Asset Pricing Model Approach

Capital Asset Pricing Model Approach Yogeshkumar Patel Davenport University FINC620- Financial Management

Running head: Capital Asset Pricing Model Approach Abstract This document looks at the Capital Asset Pricing Model and the independent variables included in the mathematical formulation. Values which fulfill the requirement for the formula include the risk-free rate of return, risk premium according to the market, and the beta

coefficient. This model provides investors with the insight on whether or not a security is worth the risk of investing with the probable return it may promise. The Capital Asset Pricing Model attempts to give an investor fairly accurate estimates which can be anticipated from a given stock based on certain values which satisfy the Capital Asset Pricing Model formula. Lastly, to better aid the discussion, a real world example of a fictitious company is given to illustrate the use of the Capital Asset Pricing Model.

Running head: Capital Asset Pricing Model Approach Capital Asset Pricing Model Approach Generally, every investor knows there are several risks involved when investing money

into the stock market. Similarly, companies listed in the stock market are aware of how much an investor is willing to risk and at what cost. So, with this in mind, how does an investor calculate the risk involved? Capital Asset Pricing Model, or simply CAPM, is a well-known method used to calculate how much risk is worth the overall return for having taken the risk in the first place. The mathematical formulation for the capital asset pricing model makes use of several factors which share a direct relationship to one another giving the cost of common stock. According to figure 1 below, by taking the beta coefficient and multiplying it by the market risk premium and adding that to the risk free rate allows one to obtain the cost of common stock. This calculation is not an absolute, rather a very accurate estimate when taken into consideration with various other methods. A closer look at what role each variable plays with their respective definition may aid in better understanding the actual model itself. The variables in the CAPM formulations are as follows. 1. rRF risk- free rate of return In terms of finance, the actual return of an investment minus the expected return is considered the risk-free rate of return, rRF. What this essentially means is that an individual who is willing to put his or her money into a particular stock is also expecting a return on that investment for however long the money was invested into the stock (Damodaran, 2008). In theory, for any investment to be risk free would mean that actual return must always equal expected return, however this is unrealistic. With this is mind, a reference point or value is

Running head: Capital Asset Pricing Model Approach needed to act as the risk free rate of return, and for this most investors choose to use the10-year Treasury bond rates. Assuming the investment is long term and not short term using values of a 10-year Treasury bond rate can provide a much less volatile estimate. 2. RPM - risk premium according to the market

In short the difference between the expected return from the market and the risk-free rate equate to the market risk premium. As mentioned previously, the risk-free rate is equal to a 10year Treasury bond yield. However, to acquire the expected return from the market is not as simple as researching the T-bond yield values. Three specific methods can be followed in order to arrive at the estimated value of the market risk premium. Risk premiums involving the past and the present must be calculated in order to estimate the future values. Naturally, the historical values do not need to be calculated rather researched from agencies like the Ibbotson Associates. Ibbotson Associates is a firm known for its expertise in gathering U.S. Securities data for decades to the most current to calculate actual realized rate of returns each year (Morningstar, Inc., 2012). 3. bi- is the beta coefficient for a specific stock The Beta- Coefficient, or simply the beta of a given stock, denoted by the lower case i indicates how volatile the said stock is relative to a market index. The usefulness of the beta does not stop there however; it can also be a useful tool in gauging the volatility of a stock within a portfolio. Hence, the beta coefficient of the market model as well as single stock portfolio model having gained a wide acceptance of as an excellent measure of risk (Klemkosky & Martin, 1975). When compared to a market index like the S&P 500, a stocks probability of over or under performance can be easily calculated based on how risky the security is.

Running head: Capital Asset Pricing Model Approach

Figure 1. Capital Asset Pricing Model Mathematical Formulation

For a better understanding of the Capital Asset Pricing Model an example will demonstrate its usefulness. Assuming the risk free rate is 5%, and the market will produce a rate of return of 12.5% within the next year. The company of interest has a beta coefficient of 1.7. With the given information, one should now wonder what rate of return should be considered a good rate for this company in order to make the risk of investment worthwhile. So for this company to be a profitable venture, after having computed using the CAPM formulation, a return of 17.5% is an acceptable value. The beta coefficient of 1.7 is a good indicator that this is a riskier company than investing in the overall market. Anything below this percentage of return should be cause for alarm and perhaps consider investments in another company. So, one can clearly see through an example that the guess work is virtually eliminated when considering investments. Additionally, the Capital Asset Pricing Model brings into realization the possibility of complete loss of monetary funds if unnecessary risk is taken.

Running head: Capital Asset Pricing Model Approach Reference(s) Damodaran, A. (2008, December). Risk Free Rate. Retrieved from What is the risk free rate? A search for the basic building block: http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/riskfreerate.pdf Klemkosky, R. C., & Martin, J. D. (1975). The Adjustment of Beta Forecasts. The Journal of Finance, 1123. Morningstar, Inc. (2012). Morning Star|US. Retrieved from Ibbotson Associates: http://corporate.morningstar.com/ib/asp/subject.aspx?xmlfile=1383.xml&ad=07Cat