Capital Asset Pricing Model (CAPM) is used to determine the required rate of return for any risky asset. The required rate of return is the increase in value one should expect based on the risk level of an asset. It mostly determines a price of an investment, when we calculate the required rate of return through CAPM that rate of return is used for discounting purposes i.e. determining the present value through future cash flows. To obtain the best risk and return combination, investors invest in market portfolio and then borrow and lend at the risk-free rate to get a desired level of risk. A portfolio is a combination of securities which has their own individual risk. The equation of CAPM which is utilized to calculate required rate of return is given as:
Re – represents require rate of return
Rf – represents the risk-free rate, which also reflects the time value of money
Rm – represents the market return which is actually a proxy for the actual market return since it is difficult to predict the actual market return as it is very vast.
β is the measure of non-diversifiable risk. It can be defined as the sensitivity of the security to the change in the return of the market portfolio.
(Rm-Rf) is called the market risk premium which is actually the reward for bearing market risk; it is the amount of return over and above the risk-free rate that investors require before they will invest in the market.
What CAPM explains?
In a well-diversified portfolio, the unsystematic unique risk gets diversified to systematic risk or portfolio risk which is measured by beta. We can see that model is similar to the equation of a line and hence, when this is plotted on a graph we get Security Market Line (SML) which is a plot of Required Rate of Return against β. It determines whether a stock is undervalued or overvalued. The investment value, when compared to its market price, can be either placed above or below the security market line.When the expected rate of return is less than the required rate of return, then the stock is called overvalued while when the expected rate of return is more than the required rate of return then the stock is called undervalued.
Capital market line(CML) is the relationship between the required rate of return and standard deviation of the security. The difference between SML and CML is that CML establishes the relationship between risk and return for diversified portfolios whereas, SML shows the relationship between risk and return for any asset.
β value is generally taken as 1, which is the market risk if β value is greater than 1 then it is considered to be aggressive stock and if it’s less than 1 then β is considered to be a defensive stock. β can also have a value of zero, in this condition required date of return is equal to risk-free rate of return. Negative β asset gives negative risk premium. It is priced to give an expected return below the risk-free rate and it does have market risk.
Investors holding well-diversified portfolio view variance as the proper measure of the risk of the portfolio which is not the relevant measure of the risk. For relevant measure individual securities contribute its co-variance with, other securities in the portfolio and we measure risk as the contribution of an individual security to the market variance.