Capital Asset Pricing Model – A Complete Beginners Guide In 2021

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Capital Asset Pricing Model

What is the capital asset pricing model (CAPM), and is it useful? Before I share anything about the CAPM, I have a couple of questions for you. 

  • Do you want to learn financial management? 
  • Are you investing in the stock market or in any other assets? 
  • Do you want to calculate the risk and reward of a particular asset?

If yes, then you should learn about the capital asset pricing model. It will help you analyze and choose an asset based on its potential risk and future prospects. Also, you will know how effective the CAP Model is and whether it really works. 

Capital Asset Pricing Model Explained

The capital asset pricing model is an important toolkit in financial management. It describes the connection between the regular risk and the required return of an investment. It can be simply securities in the stock market, or it can be business operations. The formula establishes a linear relationship between the :  

ERI= RF + 𝛃(ERP)

Where, 

ERP= ERM RF 

ERI= Expected Return on Investment

RF= Risk-free rate

𝛃= beta of the investment

ERM= Expected return of the market

ERP= Equity Risk Premium

Assumptions Of The Capital Asset Pricing Model

Here are some assumptions of the CAP Model:

  • All securities in the capital market are priced correctly. This assumption considers three factors; there are no transaction costs and taxes, all investment-related information is available free to all the investors, there are a large number of buyers and sellers in the market. 
  • Typically investors prefer to get a low return with a known risk instead of a higher return with unknown risk. 
  • Investors want to maximize the utility of their wealth.
  • Every investor expects the same risk and returns from an asset. 
  • Another assumption is all the investors are investing at the same time horizon and also sell at some similar time point in the future, but the time is undefined.

Pros and Cons of the Capital Asset Pricing Model

Before you decide whether you should use the capital asset pricing model or not, weigh the advantages and drawbacks.

Advantages Of The CAPM

The CAP Model of investment is a popular method for calculating the expected return on investment for more than 40 years. Here are some potential advantages of this method. 

  • The best thing about this model is it considers only the systematic risks that help the investors to eliminate the unsystematic risks. 
  • The formula used for calculating the expected return on investment is subjected to frequent empirical research, and it’s derived from the relationship between systematic risk and required return. 
  • It’s a better method to calculate the cost of equity than the dividend growth model. 
  • Also, it’s better than the weighted average cost of capital (WACC) for determining the discounted rate. 

Now, let’s look at some of the disadvantages of the CAP Model of investment. 

Disadvantages Of The CAPM

Although the CAP Model of investment has some potential benefits, there are also some problems with it.

  • For using the CAPM, you need to find out the values of the risk-free return rate, the equity risk premium, and the equity beta. 
  • Since the yield of short-term government debt changes regularly with the change in economic circumstances, it’s difficult to find out the risk-free rate. 
  • It’s also more difficult to find the ERP (equity risk premium). As the value of ERP is also not stable, it’s hard to get a specific value for short-term investments. 
  • Lastly, the value of the equity beta (𝛃) is also not constant. 

Now, how can investors use the capital asset pricing model practically with these problems? 

Practical Application Of The CAPM

Although the critiques and problems of the capital asset pricing model seem difficult to use, it still has some value and a useful tool in financial management. For calculating the equity beta, you can use the average of several betas. Again, you smooth out the volatility of the risk-free rate by using the short-term average value. Learn more about how to use the CAPM practically. 

Frequently Asked Question (FAQs) On The Capital Asset Pricing Model

The following frequently asked questions will help you get more clarity on the capital asset pricing model. 

What Is The Capital Asset Pricing Model Used For?

The capital asset pricing model is a technique to measure the risk of equity shares and thereby analyze the expected return on investment. Although you can apply it to other assets, it’s more relevant for the stock market.  

How Do You Calculate The Capital Asset Pricing Model?

There is a formula for calculating the expected return on investment using the capital asset pricing model. The formula goes something like this: 

ERI= RF + 𝛃(ERM RF)

Where, 

ERI= Expected return on investment

RF= Risk-free rate

𝛃= beta of the investment

ERM= Expected return of the market

What Does The CAPM Tell Us?

The CAPM tells us about the rate of return of a risky asset by comparing the relationship between systematic risk and expected return on capital investment. Apart from that, it also determines the fair price of an asset before you make an investment. 

What Are The Assumptions Of The Capital Asset Pricing Model?

The capital asset pricing model is based on the following assumptions: 

  • Typically investors prefer to get a low return with a known risk instead of a higher return with unknown risk. 
  • Investors want to maximize the utility of their wealth.
  • Every investor expects the same risk and returns from an asset. 
  • Another assumption is all the investors are investing at the same time horizon and also sell at some similar time point in the future, but the time is undefined. 

These are some of the common assumptions of the CAP Model of investment. 

The Bottom Line

I hope the article has provided you with a clear understanding of the capital asset pricing model. Although there are a lot of negative comments on this model, it has remained up above the criticism. It has remained a useful financial tool and will be used in the future until something better presents the return on investment.

Lastly, if you don’t know how to calculate your return on investment, stay tuned to learn more about analyzing an asset.

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