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The Capital Asset Pricing Model is used to determine the rate of return on a risky asset. It ascertains the relation between systemic risk and expected rate of returns. It determines expected returns of assets with the risk of those assets and also calculates the cost of capital. It can be used both for pricing a portfolio or an individual security.
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Assumptions on which CAPM is based
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r* = KRF + b(KM – KRF)
r*=required rate of return
KRF= the risk-free rate, example short-term government issued T-Bills
KM=average market return
The b=beta coefficient of security, for example, b>1 signifies risk higher than the market average and b<1 implies risk below market average.Most companies lie in the range of 0.75 to 1.50.
This called the Security Market Line Formula (SML) used for individual securities. The SML enables us to find the reward to risk ratio with the overall market.
Example to calculate the required rate of return using the CAPM
Consider the following information:
Risk-free rate of return = 5%
Average Market Return = 6%
Beta value of RD Co = 1.3
Using the CAPM:
r* = KRF + b(KM – KRF)= 5 + (1.3 x 6) = 12.8%
The CAPM predicts that the cost of equity at 12.8%.
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Disadvantages of CAPM Model
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