Question

Briefly describe the Capital Asset Pricing Model (CAPM). How is the beta coefficient defined and what does it capture? What is the meaning of alpha in the same model

Answer 1

CAPM: Capital asset pricing model:

Re = Rf + beta (Rm - Rf),

The beta is the systematic risk that the investor undertakes when investing in a particular asset. It is the risk, that the investor is exposed to. The CAPM, compensates investors for the systematic risk, which cannot be diversified away that the investor is exposed to.

Beta coefficient measures how an asset moves versus the market.

Alpha is the excess return on a security, relative to the benchmark return. It is the return , that an investor earns by not completely replicating the benchmark and using specific skills to select securities. The CAPM defines the required return form an investment. Let me explain this to you, with the help of an example:

Re = Rf + beta(Rm - RF) + alpha

Re - Rf + beta (Rm- Rf)

For example, assuming that the actual return of the fund is 35, the risk-free rate is 9%, beta is 1.2, and the benchmark index return is 25%, alpha is calculated as:

Alpha = (0.35-0.09) – 1.2 (0.25-0.09)

= 0.26 - 0.192

=6.8%

The result shows that the investment in this example outperformed the benchmark index by 6.8%.