What is the Capital Asset Pricing Model?
What in the world is beta? And how does it relate to the risk-free rate or the risk premium? We need to understand these key terms to grasp the capital asset pricing model.
Let’s first take a look at the formula:
Capital Asset Pricing Model = Risk-Free Rate + Beta (Stock Market Return - Risk-Free Rate)
The risk-free rate is the return on an investment that is guaranteed to pay us back (e.g., U.S. Treasury Bills). In our example, imagine that we could invest in U.S. Treasury Bills and receive a 1% return. If we didn’t invest in risk-free investments, we could invest in the stock market and receive a 7% return. A 1% risk-free return or a 7% risk return. We are rewarded with 6% more of a return because we take on the risk.
Now let’s move on to what beta represents. Beta is how volatile an individual company’s stock is relative to the entire stock market. Let’s say the stock market returns 7% but then the individual company International Airways returns 14%. This means we have a beta of 2 (14/7). In other words, the individual company International Airways is twice as sensitive as the overall stock market. This might seem like a positive situation, but the same applies if the stock is decreasing in value. Meaning that if the stock market were to decrease by 10%, then International Airways would lose 20%. A beta of 2 means that a stock is twice as sensitive as the overall stock market.
Now let’s plug these numbers into the formula. We first need the beta to show the individual stock’s volatility, which is 2. Then we take the difference between the stock market return of 7% and the risk-free rate of 1%, so our risk premium is 6%. We multiply the beta of 2 by the 6% risk premium to get 12%. And finally, since we initially took out this risk-free rate, we add it in at the end, so we add back the 1%.
Capital Asset Pricing Model = 1% + 2 (7% - 1%) = 13%
This means that, with this investment in International Airlines, we expect to make a 13% return. I hope that this article has been as helpful as possible!
About the Author
Kyle Ashcraft is a CPA that scored a 90+ on all four CPA exams. Kyle founded Maxwell CPA Review, which is an exam-prep company that offers a BEC course and private tutoring. Kyle can be reached at MaxwellCPAreview@gmail.com or by visiting MaxwellCPAreview.com.