Definition: The capital asset pricing model or CAPM is a method of determining the fair value of an investment based on the time value of money and the risk incurred. CAPM is used to estimate the fair value of high-risk stock and security portfolios by linking the expected rate of return with risk.
What Does CAPM Mean?
This model assumes that there are many investors with the same investment horizon and equal access to information and securities. All investors share homogenous beliefs about the investment opportunities offered in the market and are all price takers. They all borrow at a risk-free rate and pay no taxes or commissions.
This model helps these investors calculate the risk on their investments and what type of return they should expect to get based on the level of risk involved with the investment.
Let’s look at an example.
CAPM calculates the expected rate of return and discounts the expected future cash flows to their present value. The model assumes that the expected rate of return is equal to the risk-free rate plus a risk premium. Therefore, if the actual return on investment is not equal or higher than the expected return, the investment should not be undertaken.
To calculate the expected rate of return, Rs, we need to know:
- rf = risk-free rate
- rm = the expected return of the market
- b = systematic risk
Therefore, the CAPM formula is: Rs = rf + b x (rm – rf)
Pedro is an investment banking analyst at Lazard, and he wants to calculate the expected rate of return for a security. Pedro finds that the systematic risk b of the security is 1.2. He also knows that the risk-free rate is 3%, and the expected return of the market is 12%.
Pedro uses the CAPM model to calculate the expected rate of return and determine if the investment should be undertaken. Therefore:
R = rf + b x (rm-rf) = 0.03 + [1.2 x (0.12 – 0.03)] = 0.03 + (1.2 x 0.09) = 0.03 + 0.0918 = 0.1218 = 12.2%
If 12.2% is equal to or greater than the required return on investment, the investment should be undertaken.