Video Transcript: Capital Asset Pricing Model

Hello, welcome. We're going to discuss the capital asset pricing model. The  capital asset pricing model is the expected return on the market. It's a  calculation that we will do to determine what is our required rate of return on a  certain security. The expected market return is an important concept in risk  management because it is used to determine the market risk premium. The  market risk premium is part of the capital asset pricing model, or CAPM formula. This formula is used by investors, brokers and financial managers to estimate  the reasonable expected rate of return on a given investment, expected return  on an individual security, the process is similar to expected market return, only  difference is that it is finding an asset price for a single security, so expected  return on the market. So we'll have the market rate of return that is equal to the  risk free rate of return, which is typically a 10 year treasury benchmark.  Because, remember, the Treasury bills are deemed risk free because they are  backed by the government. So if the free, if the risk free rate is estimated by the  current yield on the one year treasury bill, let's assume it is 4.96% and the risk  premium is 1.39% and so the expected market return will be 6.35% you'll add  those two together, so we have the risk premium and we have the risk free rate  of return. So that will give us are market premium, which is part of the capital  asset pricing model. So when expected return on the security this is the security  market line. The security market line is a graphical depiction of the capital asset  pricing model. Now you'll see on vertical axis, you'll see the rate of return as it's  measured by beta, and how it correlates to beta. So you can see with beta, a is  less than one, so it is less volatile than the market. You'll see the return for a  would be less than the market. So less volatility means less return, so it doesn't  move as much as the market. So if the market moves, let's say a stock has a  beta of .7, and let's say the market grows 10% Well, the stock might only grow  7% so it's less volatile than the market. So if we've got a beta, let's look out at  the security market line at B. So you can see that b is greater than the return on  the market, but it also has a greater beta than one. So you can see how the  return on an asset is going to be correlated to the volatility measured by beta.  So if beta is greater than one, the security is more volatile, therefore will produce a greater return because it has more risk. And if a beta, if the beta arm of  security is less than one, it'll have less volatility, less risk, and will return less  than the market. So let's look at the formula for CAP M, so we can see our  return on an asset Ra. That is what we're trying to figure out. We're trying to  determine what is our return for this single asset. So the formula for CAP M is  the rate of return at risk, at the risk free rate. So remember, that's the Treasury  benchmark. Whatever that 10 year T bill is in the market, whatever that interest  rate is, that is what you'll plug in for your risk free rate. The one year treasury bill B is beta. Remember that measure that measures the volatility of the security  against the market. Now we need to determine our market risk premium so we  have the required rate of return, or the expected market return minus the risk 

free rate. Now we'll work our example, the shares of Aardvark Enterprises has a  beta of 1.5 shares of zebra have a beta of 0.7 the risk free rate is assumed at  3% and the difference between expected return on the market and the risk free  rate is assumed to be 8% what are the expected return on the Two securities?  So we want to compare aardvarks expected return to zebras expected return.  So let's calculate so for Aardvark, remember the risk free. Rate is 3% the return  on the market is 11% their Beta is 1.5 okay. So now let's plug it in. So risk free,  3% plus the beta of 1.5 the return on the market 11% minus the risk free at 3%  we do our order of operations first. Here's our market risk premium, 8%, 1.5 plus three continuing with the order of operations, 1.5 times eight plus three will Give  us a return of 15% so Aardvark's is aardvarks expected return 15% simple  calculation, the beta determines how risky this asset is, so it has a beta greater  than one 1.5 so it's going to be more volatile than the market. And you can tell  that we're going to capture the return from the volatility, because a 15% return  on a single security is a very reasonable return. Let's look at Zebra same thing,  risk free rate 3% plus beta. We know z we know zebras. Beta is 0.7 you know,  the market risk premium is 11% minus the 3% risk free rate, 8% remember order of operations first clear the parentheses, .7 plus three. So now we continue the  order of operations. Multiply out the parentheses, add in the 3% we have a  return 8.6% for zebra zebras, expected return is 8.6% now, because the  volatility is lower than one, you can see a lower return than the 11% market rate. This is the expected return on the market 11% remember, so the market beta is  one. Notice our beta for zebra 0.7 notice the market return is 11% we are lower  than the market return. You can see how that correlates with a lower beta.  Likewise, remember market return is 11% market beta is one. Aardvarks beta is  greater than one, 1.5 so the market return, the expected market return, is 11%  notice the premium on Aardvark at 15. So as a financial manager, you need to  determine which investment Do you want to make? Do you want to get a return  less in the market, knowing that you're going to be more risk averse and a little  more safe? Can we deal with an 8.6 return, or do we want to go with the riskier  asset with a higher volatility at the 1.5 beta, .15% it's greater risk in the market, a greater return in the market. But do we have the appetite for that risk? Those are the decisions that a financial manager has to make. You compare returns  investment decisions and make the smartest choice for your firm that's going to  help you grow your profit and enhance your portfolio