The capital asset pricing model (CAPM) is the equation that describes the relationship between the expected return of a given security and systematic risk as measured by its beta coefficient. Besides risk the model considers the effect of risk-free interest rates and expected market return.
Basic assumptions of the CAPM model are as follows.
The CAPM model allows you to assess the expected return of a given security using the following formula:
E(Ri) = RF + βi × (E(RM) - RF)
where E(Ri) is an expected return of a security, RF is a risk-free rate, βi is the beta coefficient of a security, and E(RM) is an expected market return.
Market risk premium (RPM) can be calculated as follows.
RPM) = E(RM) - RFThe risk premium of a given security (RPi) can be assessed as follows:
RPi) = βi × (E(RM) - RF)
Let’s assume an investor is thinking of buying one of three stocks: Stock A with a beta of 0.85, Stock B with a beta of 1.25, and Stock C with a beta of 1.65. If the risk-free rate is 4.50% and the expected market return is 12.35%, the expected return of each security can be assessed under CAPM.
E(RA) = 4.50 + 0.85 × (12.35 - 4.50) = 11.17%
E(RB) = 4.50 + 0.85 × (12.35 - 4.50) = 14.31%
E(RC) = 4.50 + 0.85 × (12.35 - 4.50) = 17.45%
Thus, a relationship exists between risk and the expected return of a security. So, the higher the beta, the higher the expected return and vice versa.
The capital asset pricing model is a widely used concept, but some assumptions can’t be met in real market conditions.
Stock market equilibrium is one CAPM model basic assumption, which means that the expected rate of return is equal to the required rate of return, and the current price of a given security is equal to its intrinsic value. If the stock market is in equilibrium, no securities are undervalued or overvalued. The actual stock market, however, is not in equilibrium, so both undervalued and overvalued stocks are present, and their expected return is different from the CAPM assessment.