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# Capital Asset Pricing Model (CAPM)

• What is CAPM?
• CAPM Assumptions
• CAPM Formula
• How to calculate CAPM?

## Capital Asset Pricing Model

CAPM stands for Capital Asset Pricing Model. Capital Asset Pricing Model (CAPM) defines the relationship between risk and required returns in the security market and it is used in the pricing of risky securities.

## CAPM Model Assumptions

1. Mean-Standard Deviation Analysis: We started out by assuming that individual’s preferences can be represented in terms of the mean and standard deviation of returns.

2. Investors’ Identical Believes: All investors are rational, have identical subjective estimates of the means, the variances, and covariance of returns of all assets.

3. Unlimited borrowing and lending: All investors can borrow or lend an unlimited amount at an exogenously given risk-free rate of interest.

4. Perfect markets: Markets are friction-less and there are no transactions costs. All assets are perfectly divisible, perfectly liquid so that they can be sold immediately at the market price.

5. Same after-tax returns: Taxes must be such that after-tax returns ensure that everybody faces the same efficiency locus.

6. Perfect Information: All investors have access to same information and analyze the information in the same manner.

#### How to Calculate CAPM?

As an analyst, you could use CAPM to decide what price you should pay for a particular stock. If Stock A is riskier than Stock B, the price of Stock A should be lower to compensate investors for taking on the increased risk.

CAPM Formula

The Capital Asset Pricing Model is given below:

ra = rrf + βa (rm-rrf)

where:

rrf = the rate of return on risk-free securities
rm = market’s expected rate of return
βa = beta of the asset

So let us start with the expression of the CAPM. The expression is the one that you see on the screen, and we are going to define what each of those things actually means. One the left-hand side, we have the required return on equity or the cost of equity. And you see that there are two subscripts there. The i is for any company, any company i. So if, if we look at two companies that i would go from one company to the other, Re as we said before, is the required return or the cost of equity. And the subscript i plays an important role. And we’ll clarify that in just a second. Now on the right-hand side, we have basically, what we need to calculate the cost of equity on the left-hand side. And what we need is Rf. And that stands for the Risk-Free Rate, we’ll get back to that in just a second. MRP and that stands for Market Risk Premium, which some people would call the Equity Risk Premium. Market Risk Premium and Equity Risk Premium, those two things are the same. And the last term is the beta. The same beta that we discussed in session two, is actually in session one. And we also talked a little bit about it in, in session two. It is the same beta that we talked about before, and we will have a couple of more things to say about it in just a minute. So, what is Rf? What, what is this risk-free rate? Well, the idea of the risk-free rate is, remember what we’re trying to calculate is a required return on equity, and what the risk-free rate basically tells you is the least that you would require to part with your money is, to get a compensation for the expected loss of purchasing power. Inflation erodes the purchasing power of your money. And you would not invest in anything, from which you would expect at least to be compensated for that expected loss of purchasing power. That is exactly what the risk-free rate is. If you actually look at the long-term short-term risk-free rate government bond yields, and inflation rate these two are very closely correlated. That means that the risk-free rate is simply a compensation not for bearing risk. But for the expected loss of projection power. Now you would say, and you would be right if you say, but wait a minute I am investing in a company, and, and a company is risky. I may lose my money. Well, that is why we have a second term. The second term if we put MRP times beta.