The Capital Assets Pricing Model

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The Capital Assets Pricing Model

Introduction

The Capital Assets Pricing Model (CAPM) , is a method of pricing assets of capital nature. This model applies Beta (non-diversifiable risk) to link risks and returns of investments. According to Stahl (2016), Beta is a standard for measuring the systematic risk or the non-diversifiable risk. The uncertainty in the economy of a particular country causes the systematic risk. Systematic risk is that risk sharing or risk diversification cannot reduce. Economic downturns, war, natural calamities and a change of government policy are some of the activities that cause systematic risk. Both CAPM and Beta are measures of risk (Anon 2014). The capital assets pricing model defines the required rate of return of security. CAPM can be a mathematical equation, or a graphical representation is known as the security market line (SML) (Stahl 2015). An analysis of CAPM indicates that there are several critiques of this model. Nevertheless, there are multivariate models used to overcome these critiques.

A).Formulas to Calculate CAPM and Beta

1). Capital Assets Pricing Model

CAPM= [pic]= [pic]+ [pic] (RM-RF)

Where; [pic] is the cutoff rate or even minimum required rate of return
RM- RF is the risk premium and is above free rate RM is the market returns [pic] is the risk-free rate of returns [pic] is the beta of asset j
Illustration
Assuming that [pic]= 1.2, RM= 12% and [pic]= 4%. Use the CAPM to calculate the required rate of return.
Solution
CAPM= [pic]= [pic]+ [pic] (RM-RF)

[pic]= 4+1.2 (12-4)
[pic]= 4+ (1.2 x 8)
[pic]= 4 + 9.6
[pic]= 13.6 %
2). Beta
[pic]= [pic]
Where; [pic] is the covariance between the market and asset j.