the capital asset pricing model or cap m The capital asset pricing model explains the relationship between expected return and Market risk. It is one of the most significant Innovations in portfolio history. The model is simple yet powerful intuitive yet profound and uses only one factor and yet it is broadly applicable.
Cap m is based on the idea that only Market risk should affect asset prices. No other factors are considered systematic risk is a risk that cannot be avoided and is inherent in the overall Market. It is non-diversifiable because it includes risk factors that are innate within the market and affect the market as a whole IE interest rates economic growth Etc.
Examples of non-systematic risk could include the failure of a drug trial major oil discoveries or an airliner crash investors are capable of avoiding non-systematic risk through diversification by forming a portfolio of assets that are not highly correlated with another cap M asserts that the expected return of assets very only by their systematic risk as measured by Beta.
The formula for cap M states that the expected return which can also be called. The required return is equal to the risk-free rate plus the beta times the market risk premium or expected risk premium, which is the difference between the expected market rate and the risk-free rate capm asserts that the expected returns of assets very only by their systematic risk as measured by Beta two assets with the same beta will have the same expected return irrespective of the nature of those assets.
Given an assets systematic risk, the expected return can be calculated using cap M. The risk-free rate is 3% while the stock for ABC company has a beta of 1.5 and the market risk premium is 6% What is the expected return for ABC stock 3% plus 1.5 times six percent or twelve percent if beta is greater than 1 you would generally expect the asset to have a higher respected return than the overall Market.
The risk-free rate in theory is the rate of return of an asset that produces a constant known rate of return in all future economic States practically speaking the rate of return of an investment with guaranteed or nearly guaranteed cash flows. Sovereign debt is often used as a proxy for example us treasuries or German treasuries. This is the rate that serves as a reference rate for valuing other Investments.
Let's consider a hundred investors with one year time Horizons each buying a one-year treasury bill or any other default-free one-year bond with a 2% expected return after year one. The return for all investors would always be to percent. It is important to note that the realized return is not certain if sold before one year also keep in mind while government bonds may offer returns that are risk-free and nominal turns. They are not risk free in real terms since expected inflation can be volatile cat bam only considers one aggregate metric of Market risk, and that is beta it assumes investors own Diversified portfolios, which means that they don't get rewarded for unsystematic risk as it should be Diversified away.
Remember beta tells us about one type of risk Market risk. It's not a measure of an investment's total risk and low beta or zero beta does not necessarily mean an investment has no volatility or risk on an absolute basis the Returns on a stock with a beta close to one will move with the market the Returns on a stock with beta less than one have less Factor risk than the market and vice versa for stock with the beta greater than one the beta and correlation are related correlation indicates the strength of the linear relationship between a stock and the market on the other hand the beta tells you the change in the response for a one unit increase in the market or factor correlation does not have this kind of interpretation beta essentially standardizes price movements inputs them on the same scale, which allows you to compare the magnitude of Market movements directly the cap M Market risk premium is the return demanded for taking equity market-wide.
This is also known as the equity risk premium.
Actual returns earned on stocks over a long period of time are calculated and compared to the actual returns earned on a default free note that even with only three slices of History considered the premiums can range widely depending upon the choices made that is the time period the average method the market index and the risk-free security chosen. It is not surprising there for that. The equity risk premiums used by analysts reflect this uncertainty with why differences across analysts on the number used. The choice of time periods has trade-offs longer periods. Give more data points. Thus a common choice is to use the longest reliable return series available. However, many will question whether data from the 1920s is really relevant in today's market estimating Market risk premium is based only on expectations of future economic and financial variables historic mrps are ignored. These are also called X anti-estimates the dividend discount.
Model approaches the simplest and most common forward-looking approach here the market or Equity risk premium is equal to the dividend yield on the index based on the year ahead. Aggregate forecasted dividends in aggregate Market Value Plus the consensus long term earnings growth rate less the current long-term government bond yield.
There are two methods of calculating the market risk premium one uses macroeconomic models in the other is the survey method economic variables included in these models vary, but on the macro side, they could include the estimate of earnings growth inflation valuation multiple growth or dividend growth the survey approach consists of asking agents about the current level of the equity risk premium or Market risk premium surveys incorporate the views of many people some of which are very sophisticated and/or make real investment decisions based on the level of the equity risk premium.
The security Market line is used by investors in evaluating a security for inclusion in an Investment Portfolio in terms of whether the Security offers a favorable expected return against its level of risk. We plot the expected or required return against the systematic risk beta it is important to understand that the cap M and the security Market line or SML our functions that give an indication of what the return in the market should be given a certain level of risk. The actual return may be quite different from the expected return When the security is plotted on the SML chart if it appears above the SML, it is considered undervalued because the position on the chart indicates that the Security offers a greater return against its inherent risk So in theory, it should be purchased conversely if the security plots below the SML, it is considered overvalued in price because the expected return Not overcome the inherent risk Securities with beta is less than one are often called Defensive Securities. And those with beta is greater than one are often called aggressive securities.
