Capital Asset Pricing Model (CAPM): Pros and Cons.
CAPM defines the relationship between risk and return. The premise of the model is that the expected investment return varies in direct proportion to its risk, i.e., the riskier the investment - the higher the return you should expect. Shows:
how much risk you are taking when investing in an instrument? •
whether the instrument is rightly priced
whether you are getting sufficient return for the risk you are taking
CAPM calculates the risk-adjusted discount rate with the risk-free rate, the market risk premium, and beta (mathematical formula):
Return (R) = Rf + beta x (Rm - Rf)
Rf is the rate of risk-free investments
Beta - the risk of loss associated with your investments.
Rm is the expected market return.
(Rm-Rf) – market risk premium
beta x (Rm - Rf) – risk premium of specific company
Investments are good if the expected return from the investment equals/exceeds required return.
Market Risk Premium [Rm-Rf]
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk Its size depends on the perceived risk of the overall stock market and investors’ degree of risk aversion Varies across time. Usually ranged between 4-8%
BETA in CAPM measures a stock’s degree of systematic or market risk. It can also be thought of as the stock’s contribution to the risk of a well-diversified portfolio •
beta = 1 the stock has average market risk. The stock generally tends to go up (down) by the same percentage amount as the market •
beta = 1.5 the stock generally tends to go up (down) by 50% (1.5x) more than the market •
beta = 0.5 the stock generally tends to go up (down) by half as much as the market •
beta = 0 the stock has no correlation with movements in the overall stock market. All of the firm's risk would actually be firm-specific risk •
beta < 0 the stock generlly tends to move in a direction opposite that of market (very rare)...
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