Question

please describe the main content of capital Asset pricing model (CAPM) .Is CAPM practical?

Answer 1

CAPM model is used to identify the expected return of the stock on the basis of risk free return, its beta and market return. This expected return of the stock is also used as require rate of return ( cost of equity capital) in equity or company valuations.

CAPM model is given as follows:

Expected return = Rf + *(Rm-Rf)

Here, = Beta or market risk of the stock

Rf = risk free return

Rm = market return

*(Rm-Rf) = risk premium

Above CAPM model shows that it is the Beta and market return that drives the expected return of the stock. A higher Beta and higher Market return , will lead to the higher expected return of the stock.

CAPM is practical, but in a limited extent, because it does not consider other factors such as market capitalization, book value value into the consideration. To sort this issue, Fama French model is developed.