Capital Asset Pricing Model: Parameter of Deciding Risk Rate

Definition of Capital Asset Pricing Model

Capital asset pricing model (CAPM) is acute practice that serves to determine a theoretically appropriate required rate of return of an asset in the finance discipline. CAPM can be interpreted as the relationship between the risk and expected return, and that is used in the pricing of risky securities.

The general idea behind CAPM

There are two ways that investors can be remunerated, and one is time value of money and other is risk management.

• The time value of money is deciphered as risk rate (rf) in the formula, compensate investor by providing money over a period.

• Other half is dedicated to risk and calculates the amount of compensation the investor gets if he is taking additional risk. The formula went as the calculation of the risk measure (beta) which compares the availability of the asset on the market within a long time period and to the market premium (Rm-rf).

Books on Capital Asset Pricing Model

Book 1:

Modern portfolio theory, the capital asset pricing model, and arbitrage pricing theory by Diana R. Harrington (published by Prentice-Hall, 1987)

Book 2:

Principles of the Capital Asset Pricing Model and the Importance in Firm Valuation, By Nadine Pahl (published by BoD – Books on Demand)

How Capital Asset Pricing Model works?

If you are an analyst, Capital asset pricing model can be useful to decide many things. With the help of a few useful examples, Capital asset pricing model can be defined.

• As an analyst, if you want buy particular stocks, Capital asset pricing model can assist the analyst to dictate the price value of a particular stock. Suppose there are stock X and stock Z, if on a given situation it is defined as that stock X is riskier than stock Z, then the price value of stock X would be lower than the stock Z, in order to compensate the investor for taking additional risk.

• As the next example, if you want to determine the Stock XYZ's required rate of return over 10 year time horizon, you will have to use CAPM with the 10-year U.S. Treasury bond rate which are used as a proxy in for the risk-free rate for deciding the risk free return.

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