Capital Asset Pricing Model (CAPM)

•Expected Return on the Market - 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, in turn, is part of the capital asset pricing model, (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 – process similar to expected market return, only difference is that it is finding an asset price for a single security.


Expected Return on the Market



If the risk-free rate, estimated by the current yield on a one-year Treasury bill,

is 4.96 percent, and the risk premium is 1.39 percent the expected on the market
is:

6.35% = 4.96% + 1.39%


Expected Return on an Individual Security



•The Security Market Line (SML) is the graphical depiction of the capital asset pricing model (CAPM)
•The expected return on a security with a beta of 0 is equal to the risk-free rate.
•The expected return on a security with a beta of 1 is equal to the expected return on the market.


Expected Return on an Individual Security



This is the Capital Asset Pricing Model (CAPM)


CAPM Example


•The shares of Aardvark Enterprises have a beta of 0.7. The risk-free rate is assumed 3%, and the difference between expected return on the market and the risk-free rate is assumed to be 8.0%. What are the expected return on the two securities?
•

Aardvark expected return:
  15.0% = 3% + 1.5 x 8.0%

Zebra expected return:
  8.6% = 3% + 0.7 x 8.0%













Last modified: Tuesday, August 14, 2018, 8:45 AM