Capital Asset Pricing Model (CAPM)

Last updated: 16.03.2016

Capital Asset Pricing Model (CAPM) is used to calculate the expected rate of return on particular security.  As such, it is used to estimate the cost of equity. The variables of CAPM can be drawn by Security market line (SML).

 

CAPM formula:

risk-free rate + β * market risk premium

where:

market risk premium (P) = (expected market return – risk-free rate) → excess return of the entire market or market segment over risk-free rate

risk-free rate: often the yield on government bonds

coefficient β: a ratio of systematic risk attached to the company equity shares compared to risk present in the market:

  • β > 1 → the particular share is more risky (volatile) than shares in the market (38) (e.g.  company share price will rise more quickly than average share in the market segment)
  • β < 1 → the particular share is less risky (volatile) than shares in the market (38)

 

Disadvantages of CAPM

  • CAPM assumes that there is linear relationship between the systematic risk and expected return
  • risk-free rate also varies with the length of maturity
  • all the CAPM formula components becomes out-of-date over time

 

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Used sources:

38. Definition of „Systematic Risk“ (online). Citation date: 29.1.2016. Available from www:  http://www.investopedia.com/terms/s/systematicrisk.asp



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