Capital Asset Pricing Model : CAPM

Definition: Capital Asset Pricing Model (CAPM) is a method used to rate  stocks given their limited cash.

More Detail: The CAPM estimates potential rate of return on a stock given the stock’s level of risk.

 It is easy to know the rate of return for savings account or a bond (Example: 3% Savings Account or 6% Coupon Bond).  But how to you figure the rate of return on a stock before you buy it?

For example, if you wanted to buy Apple stock (AAPL), there is no label that says, “AAPL Return = 15% per year”.

One of the methods to estimate a stock’s rate of return is using the Capital Asset Pricing Model (CAPM)
Formula
   R(a) = R(f) + β [R(m) – R(f)]

Where:

                                        R(a) = Expected rate of return on the stock, portfolio

                                        R(f) = Risk free rate

                                        β = beta of security/systematic risk

                                        R(m) = expected market return

What does it mean?

 It is a model that estimates the relationship between risk and expected return. The first part of the formula R(f) is the rate investors get if they were going to invest money risk-free.

The second part β [R(m) – R(f)] is a Beta factor (risk) for investors for accepting risk and investing in that particular security.

According to the model, you can use the CAPM to calculate rate of return.  This expected return is compared with the required rate of return for the investor. If the model shows the potential rate of return is greater than the investor’s required rate of return then the investor should invest in the stock.  But if CAPM shows a lower rate of return than expected by the investor, then the investor should not buy that security

Example

Expected return on Apple ( AAPL) stock for 1 year can be calculated using the CAPM model

To get the market return we consider the S&P500 = R(m)

1 year average return on S&P 500 = R(m) = 14%

Risk Free Rate (Savings Account at ING Direct) = R(f) = 2%

Beta of Apple stock = β = 1.35

Using CAPM;

R(a) = R(f) + β[R(m) – R(f)]

R(a) = 0.02 + 1.35[0.14 – 0.02]

R(a) = 18.20%

Results:  The expected return on the Apple stock is 18.20%

Practice this on HTMW

You can practice trading for real on HTMW based on CAPM by:

(a)  Finding the desired holding period risk free rate

(b)  Finding the Stock’s Beta (Google Finance has an estimate of Beta on most stocks)

(c)  Taking an average of the S&P 500 historical prices for the desired time –period you want to hold the stock

(d)  Calculating the CAPM from the formula

(e)  And finally, seeing if CAPM holds by trading and holding the stock using the HTMW Virtual Trading Platform.
Conclusion

CAPM is a useful tool to find the expected return of a stock or portfolio. The model depends upon how much risk there is. Hence if we know the value of the Beta, which is a measure of risk, the approximate expected return of the stock can be easily calculated using the CAPM formula.

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