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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. If you want to understand it better, try Estimating the CAPM Inputs Assignment Help.
The CAPM Inputs
The CAPM Pricing Model defines the required return for a specified level of risk.
The CAPM Pricing Model requires three inputs, and they are:
- Risk-Free Return-Return with minimal risk.
- The Rate of Return from the Market- the market where the stock in question is being traded.
- The beta value the risk level-b>1 signifies risk higher than the market average and b<1 implies risk below market average. Most companies’ beta lie in the 0.75 to 1.50 range.
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Estimation of CAPM inputs:
- Risk-Free Rate-
Always Use a longer tenure interest rate for T-Bills say for ten years or more as it allows changing returns over a longer period. Don’t hold only a single government bond for ten years instead buy one-year bonds for every ten years. A single ten year will provide a better return as compared to multiple one-year bonds and hence greater the risk. The Inter Temporal CAPM employs an instantaneous interest rate and based on this you might want to use a short-term interest rate. But in this case, inflation is not considered as it changes with time and so it’s better to use a long-term interest rate.
- Beta Value-
Generally we try to reduce the risk by using the average of all equity beta companies available in the market. You must try to use over five years of estimation data while calculating the beta because in the real-world transaction costs associated matter. Betas for projects are estimated using beta from a comparable company in the business. Does every beta equal one plus or minus the estimation error? Firms with low beta estimates may tend to have unexpected high return correlations with the market. The reverse also may be true too. On average betas have to equal one.
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- Rate Of Return from the market-
It is used to determine the market risk premium. The rate represents the percentage of total returns compared to the volatility of the stock exchange. It is calculated using expected return minus the risk-free rate.
For example, If the NASDAQ generated a 8% return rate last fiscal, this rate may be referred as the expected rate of return for any investment done in the companies residing in that index. Suppose the present return rate for short-term T-bills is 6%, the market risk premium is 8% – 6%, or effectively 2%. But, the returns on lone stocks may be actually high or low depending on their volatility.
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