The Capital Asset Pricing Model (CAPM) estimates the expected rate of return for a stock based on its beta risk, with higher risks justifying higher returns. The formula starts with the risk-free rate and calculates the premium generated by investing in the stock market above a risk-free asset. The Security Market Line (SML) graph compares a company’s actual returns to the expected return based on its beta, with stocks below the line performing poorly and those above it being undervalued.
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 laureate economist William Sharpe first proposed the CAPM in 1970. The appropriate return for a security is estimated using the asset’s beta risk, which is a measure of the security’s relative volatility relative to the market. The CAPM is based on the assumption that higher risks justify and should produce higher returns. Using the equity asset pricing model, an investor can ascertain whether the current share price is consistent with the expected rate of return.
Assets with zero beta are relatively risk-free. The formula used by the asset pricing model starts with the risk-free rate of return, for example, the rate on a 10-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 median market return gives the extra amount an investor should get when investing in the stock market above a risk-free asset. In order to generate an estimate of a reasonable and expected rate of return, the premium is then multiplied by the beta of the individual security and added to the risk-free rate.
For example, if a 10-year Treasury bond yields two percent, the risk-free rate is two percent. If the market rate is 10 percent, the premium generated by investing in the stock is 16 percent, derived by subtracting the risk-free two percent from the market rate. Company XYZ has a beta risk of two. The premium that an investment in Company XYZ would produce over the risk-free rate is calculated by multiplying by two times eight. XYZ Company’s stock is expected to generate an 18 percent bonus over the two percent or XNUMX percent risk-free rate.
The security market line (SML) is a line graph of the asset pricing model system, with beta plotted on the horizontal axis and the asset’s return on the vertical axis. Sloping up to the right, the line represents the relationship between beta and expected return. When investors compare a company’s actual returns on this chart, stocks that generate returns below the line perform poorly, with the return not justifying the risk. On the other hand, if the actual yield tracks above the line, the stock is undervalued. This action is the real deal.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
