Compute the expected return on an investment using the Capital Asset Pricing Model.
e.g., 10-year Treasury yield
Stock's systematic risk
Expected market return
Expected Return E(R)—
Market Risk Premium—
Risk Premium (β adjusted)—
CAPM Formula:
E(Ri) = Rf + βi × (Rm − Rf)
Where:
E(Ri) = Expected return of investment
Rf = Risk-free rate
βi = Beta of the investment
Rm = Expected market return
(Rm − Rf) = Market risk premium
What is the Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) is a foundational financial model developed by William Sharpe, John Lintner, and Jan Mossin in the 1960s. It describes the relationship between systematic risk (beta) and expected return for assets, particularly stocks. CAPM is widely used in finance for pricing risky securities and calculating the cost of equity capital.
Understanding the Components
Risk-Free Rate (Rf): The return on a "zero-risk" investment, typically the yield on government Treasury bonds (e.g., 10-year US Treasury). This represents the time value of money.
Beta (β): A measure of a stock's volatility relative to the overall market. A beta of 1.0 means the stock moves with the market. Beta > 1 indicates higher volatility; beta < 1 indicates lower volatility.
Market Return (Rm): The expected return of the overall market, often approximated by the historical average return of a broad index like the S&P 500 (~10% annually).
Market Risk Premium (Rm - Rf): The additional return investors expect for bearing market risk above the risk-free rate.
Example Calculation
Suppose the risk-free rate is 4.5%, the stock's beta is 1.3, and the expected market return is 10%: