The CAPM is used in finance to compute an expected return on an equity investment. Learn about the components of the CAPM.
- It's time to talk about what is probably the most famous finance model, the Capital Asset Pricing Model or the CAPM. - Now, the CAPM is the expected return provided by an investment given its risk. The official formula for the CAPM is as follows. Expected return equals the risk-free rate of return plus an equity risk premium multiplied by beta. - [Man With Glasses] So let's break this equation down into its components. Let's start with the risk-free rate. - Now, the risk-free rate on an investment is the rate of return on an investment that has zero risk.
The closest thing you can get to a zero-risk investment is the three-month US Treasury Bill Rate as there is little chance that the US government is going to default on that obligation. - Let's hope there's little chance. So over the last 50, 60, 70 years worldwide, the risk-free rate has been about 5%, that's just an approximation. So when you think about risk-free rate, I want you to have that number in your brain. 5% is a good approximation over time of the risk-free rate, 5%. - [Man Without Glasses] Now, another important element of the capital asset pricing model is something called the equity risk premium so let's talk about that for a moment.
- So in this context, equity means an investment in the ownership shares of a company. Equity stock investments, that's what we're talking about here. - And the simple insight is this. An investment in the stocks of a company is more risky than say an investment in a bank account so there should be a high rate of return. If you invest in a bank account, almost no risk at all so the expected return there is quite low. - But if you go and invest in stocks, then there's much more risk so you'll expect to receive a high return. The equity risk premium is the extra amount that you expect to earn on your investment because you're investing in risky assets.
- Now, in the United States for example, over the last 50, 60, 70 years, an investment in stocks has averaged a return of about 10 or 11%. That means that the extra amount earned for an equity investment is 6% or 11% in your equity return minus the 5% risk-free rate. This 6% is called the equity risk premium. - Now, there certainly are a lot of factors that can affect the risk-free rate like inflation and time horizon and there are a lot of factors that can affect their equity risk premium like the size of the firm, the firm's geographic location.
- Sure, we can make this a lot more complicated, but at this point, we're just trying to get our arms around the concepts included in the capital asset pricing model. So for now, let's just go with a risk-free rate of 5% and an equity risk premium of 6%. So here's our CAPM equation so far. The expected return equals 5% plus 6% times beta. That just leaves us with beta so what is that? - So beta is a measure of the volatility of an individual security return relative to the market as a whole.
Beta amplifies the expected risk premium. A beta of greater than one indicates a riskier investment which means the risk premium is greater. A beta of less than one indicates a less risky investment relative to the market as a whole. And as a result, the expected risk premium is less. - So consider the example of Ford Motor Company. If you're fearful of your job, if the economy is going down and you're fearful of a recession, you're not going to run out and buy a car. So when there's a little downturn in the economy, Ford Motor sales go way down.
- But then when the economy goes back up, lots of people want to buy cars. They've got this pent-up demand so Ford Motor Company sales go way up. That's reflected in a high beta. Ford's beta is about 1.8. Using the capital asset pricing model, that means that our expected return for Ford is 15.8% computed as follows. So there's 5%, that's the risk-free rate, plus 6%, the equity risk premium, time Fords beta of 1.8. That means we got the risk-free rate of 5%, plus the 10.8% equity risk premium in total adjusted for beta, that's a total expected return of 15.8%.
Now because of the risk associated with an investment in Ford, investors expect a higher return. - Now contrast that with Walmart with a beta of 0.36. Walmart's beta is quite low because even when the economy is down, you need to buy clothes and you need to buy groceries. The expected return for Walmart then is 7.16% computed as follows. The expected return equals 5% plus 6% times Walmart's beta of 0.36. In other words, the expected return equals 5% plus 2.16% or 7.16%.
- An investment in Ford involves more risk. Thus, investors require a high return for their investment. An investment in Walmart is less risky, requiring a low-end return. - Now, the capital asset pricing model is a powerful, relatively simple way for computing the expected return on an investment being considered. - [Man With Glasses] It weighs the return expected for a risk-free investment and then factors in the overall risk associated with an investment in stocks in general as the equity risk premium and then includes a modifier for the risk associated with a specific company being considered.
That's the beta. - The capital asset pricing model considers the risks associated with the overall markets as well as the risks associated with a specific company. Investors in equity markets need to be compensated for both of these components.
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