Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a common formula used to find the expected return for investing in a company.

CAPM = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)

The risk-free rate is the return that a risk-free investment provides (i.e., you’re guaranteed to receive the return). A US Treasury bill is a good example of a risk-free investment. For this example, let’s say that we could invest in a US Treasury bill and get a 1% return (i.e.,1% is the risk-free rate). Let’s say that if we invest in the stock market, we could get a return of 7% return (i.e., market return).

We can choose a risk-free investment and receive a 1% return, or we can choose a risky investment and receive a 7% return. We are rewarded with a 6% higher return for taking on the risk. In other words, our risk premium is 6%.

Now let’s talk about beta. Beta is how volatile an individual company stock is in relation to the overall stock market. A beta of one means that the stock would move exactly the same as the overall stock market. Let’s say the stock market returns an average of 7%, but a particular company called International Airways returns 14%. This means that International Airways moves twice as much as the stock market does (i.e., it’s twice as volatile as the stock market). This is great if the stock increases in value, but the reverse also applies if there’s a decrease in value. If the stock market were to lose 10%, the stock of International Airways would lose 20%.

Study Tip: Beta is how volatile an individual company stock is in relation to the overall stock market. A beta of 2 means the individual company is twice as sensitive to price changes as the overall stock market.

For the CAPM formula, we multiply beta by the risk premium (market return – risk-free rate) because each stock has a different level of volatility in comparison to the overall stock Market.

Now let’s plug these numbers from our example into the CAPM formula. The beta for this stock would be 2. Then we take the difference between the stock market return of 7% and the risk-free return is 1%, for a risk premium of 6%. We multiply the beta of 2 by the risk premium of 6%, which equals 12%. 

Then, since we took out the risk-free return of 1% to calculate the risk premium, we add back the risk-free rate of 1% at the very end. Therefore the CAPM would equal 13%.

CAPM of 13% = Risk-Free Rate of 1% + Beta of 2 (Market Return of 7% – Risk-Free Rate of 1%)