Question

1. What is CAPM? How is it defined? What does the CAPM provide and what is it based on? How is the CAPM conceptually related to the “risk – return story”?

Answer 1

CAPM

Capital asset pricing model describes the relation between expected return on a security and the systematic risk (beta) of the market.

Systematic risk is the risk of the market which is caused by factors which are outside the control of the firm.

CAPM equation is widely used to calculate expected return on the security. As per CAPM there is positive and linear relationship between expected return and systematic risk as measured by beta.

CAPM equation -

E(Ri) = Rf + ( E(Rm) - Rf ) * beta of security

where,

E(Ri) = Expected return on security i

rf = risk free return

E(Rm) = Expected market return

Note : ( E(Rm) - Rf ) is nothing but market risk premium and ( E(Rm) - Rf ) * beta of the security is risk premium on the security i.e return undertaken for taking extra risk.

CAPM provides the expected return on the security.

The actual value of the stock can be compared to the expected return on the stock to find out if the stock is undervalued or overvalued. If the required rate of return is greater than the estimated return, then the stock is overvalued or vice versa.

The CAPM is related to risk and return story as it provides the relation between expected return on a security and the systematic risk (beta) of the market. Greater the beta of the security greater will be the expected return.

Hope it helps!