The Capital Asset Pricing Model (CAPM) uses beta risk to determine the expected rate of return and assess the systematic risk of investing in a stock. The formula is: Expected return = Risk-free rate + Beta (Market rate – Risk-free rate). The Security Market Line (SML) graph compares actual returns to expected returns, with stocks above the line being undervalued and those below being underperformers.
The asset pricing model or capital asset pricing model (CAPM) is a means of assessing the systematic risk of investing in a stock and determining the expected rate of return. Nobel Prize-winning economist William Sharpe first proposed CAPM in 1970. A stock’s appropriate return is estimated using the asset’s beta risk, which is a measure of the stock’s relative volatility compared to the market. CAPM is centered on the assumption that increased risk justifies and should lead to higher gains. By using the capital asset pricing model, an investor can determine whether the current stock price is consistent with its expected rate of return.
Zero beta assets are relatively risk free. The formula used by the asset pricing model opens with the risk-free rate of return, for example, the rate on a ten-year Treasury bond. Written, the formula is as follows: Expected return = Risk-free rate + Beta (Market rate – Risk-free rate). Subtracting the risk-free rate from the average market return provides the additional amount an investor should earn from investing in the stock market over and above that of a risk-free asset. To generate an estimate of a reasonable expected rate of return, the premium is then multiplied by the beta of the individual shares and added to the risk-free rate.
For example, if a 10-year Treasury bond yields 2 percent, then the risk-free rate is 2 percent. If the market rate is 10 percent, then the premium generated by the stock investment is eight percent, obtained by subtracting the risk-free two percent from the market rate. Company XYZ has a beta risk of two. The premium that the investment in Company XYZ should produce over the risk-free rate is calculated by multiplying two times eight. Stock in Company XYZ should earn a 16 percent bonus on top of the two percent risk-free rate, or 18 percent.
The Security Market Line (SML) is a line graph of the asset pricing model system, with beta plotted on the horizontal axis and asset return on the vertical axis. Sloping upward to the right, the line represents the relationship between beta and expected return. If investors compare a company’s actual returns to this plot, stocks that yield returns than the plot below the line are underperformers, and the return does not justify the risk. On the other hand, if the actual return plots above the line, the stock is undervalued. This action is a bargain.
Smart Asset.
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