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    Guide To Capital Asset Pricing Model!

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    Aryan Hate

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    Guide To Capital Asset Pricing Model!

    Uploaded by

    Aryan Hate
    2 views11 pages

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    Guide to Capital Asset Pricing Model!

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    Copyright:

    © All Rights Reserved
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    2 views11 pages

    Guide To Capital Asset Pricing Model!

    Uploaded by

    Aryan Hate

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 11

    Simple Guide to

    CAPITAL ASSET PRICING MODEL


    (CAPM)
    Ever wondered how much return you should
    expect from an investment?

    Knowing the potential return on your


    investments is crucial whether you're a seasoned
    investor or just starting out.

    This is where the Capital Asset Pricing


    Model (CAPM) comes into play.
    CAPM
    The Capital Asset Pricing Model (CAPM) was
    developed by William F. Sharpe, John Lintner, and
    Jan Mossin in the 1960s.

    It is a tool used to determine the expected return


    on an asset, considering its systematic risk
    (market risk) relative to the overall market.
    CAPM Formula

    E(Ri) = Rf+ βi (Rm−Rf)

    Where:
    E(Ri) = Expected return of the investment
    Rf = Risk-free rate
    βi= Beta of the investment
    Rm = Expected return of the market
    Rm−Rf= Market risk premium
    A Simple Example to
    Understand
    Imagine you are considering investing in a stock
    with a beta of 1.2.

    The risk-free rate is 3%, and the expected return


    of the market is 8%.

    Using the CAPM formula:

    E(Ri​)= 3% + 1.2 × (8%−3%)


    E(Ri​)= 3%+1.2 × 5%
    E(Ri​)= 3% + 6%
    E(Ri​)= 9%

    The expected return on the stock, according to


    CAPM, is 9%.
    Components of CAPM
    1. Risk-Free Rate (Rf): This is the return on an
    investment with zero risk, typically government
    bonds. It represents the minimum return
    investors expect for any investment.

    2. Beta (β): Beta measures an investment's


    volatility compared to the market. A beta
    greater than 1 indicates higher volatility, while a
    beta less than 1 indicates lower volatility.

    3. Market Risk Premium (Rm - Rf): This is the


    additional return investors expect from the
    market over the risk-free rate.
    Capital Asset Pricing Model (CAPM)
    Interpretation of the Graph
    When Beta = 1.0, the expected return (Ra) is
    equal to the market return (Rm). This is because
    it has the same risk as the market.

    When Beta = 0.0, the expected return (Ra) is


    equal to the risk-free rate (Rfr). This implies no
    risk, thus earning the risk-free rate.

    When Beta > 1.0, the expected return is higher


    than the market return due to higher risk.

    When Beta < 1.0, the expected return is lower


    than the market return, reflecting lower risk.
    Why is CAPM Important?
    1. Investment Decisions: CAPM helps investors
    determine if a stock is worth the risk by
    comparing the expected return to the required
    return.

    2. Portfolio Management: It assists in creating a


    diversified portfolio by evaluating the risk and
    return of each investment.

    3. Cost of Equity: Companies use CAPM to


    calculate their cost of equity, which is crucial
    for capital budgeting and financial planning.
    Limitations of CAPM
    While CAPM is a powerful tool, it has its limitations:

    1. Assumptions: CAPM assumes that markets are


    efficient and that all investors have the same
    expectations, which is not always the case.

    2. Beta Reliability: Beta is based on historical data


    and may not accurately predict future volatility.

    3. Single Factor Model: CAPM only considers


    market risk and ignores other factors that
    might affect an investment's return.
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