• Home
  • Finance
    • Financial Management
    • Strategic Management
    • Investment Analysis and Portfolio Management
    • Project Management
    • Islamic Banking & Finance
    • Auditing
  • Marketing
    • Principle of Marketing
    • Marketing Management
    • International Marketing
    • Advertising & Promotion
    • Commercial Challenges
  • HRM
    • Human Resource Management
    • Principles of Management
    • Training & Development
    • Employee Performance Management
  • Others
    • Introduction to Business
    • Business Communication
    • Banking & Finance
    • Entrepreneurship
    • Economics
  • Personal Skills
  • Tips & Tricks
  • About Us
    • Contact US

Business Study Notes

B.Com, M.Com. BBA & MBA Exam Study Online

  • Home
  • Finance
    • Financial Management
    • Strategic Management
    • Investment Analysis and Portfolio Management
    • Project Management
    • Islamic Banking & Finance
    • Auditing
  • Marketing
    • Principle of Marketing
    • Marketing Management
    • International Marketing
    • Advertising & Promotion
    • Commercial Challenges
  • HRM
    • Human Resource Management
    • Principles of Management
    • Training & Development
    • Employee Performance Management
  • Others
    • Introduction to Business
    • Business Communication
    • Banking & Finance
    • Entrepreneurship
    • Economics
  • Personal Skills
  • Tips & Tricks
  • About Us
    • Contact US
Home » Explain Capital Asset Pricing Model in Detail

Explain Capital Asset Pricing Model in Detail

By Richard Daniels Reading Time: 4 mins
Updated August 8, 2020

Capital Asset Pricing Model:- Before going into detail of the capital asset pricing model (CAPM), let’s discuss some of the basic concepts of Risk and Return theory that is helpful in understanding CAPM.

Asset Pricing Model

  1. Risk

Risk is the combination of dangers and opportunities, or the volatility or spread, or uncertainty of the future outcomes over investment is called risk. Risk is measured in terms of standard deviation. Risk of a project is composed of two types.

Diversifiable Risk

It is the Risk that can be reduced through diversification in investments in uncorrelated projects. The unfavorable random events of one project are equalized through the favorable events of other projects.

Market Risk:

It is that part of total risk that cannot be reduced through diversification. It is related to the unfavorable socio-political and economic events that are taking place globally and that affects almost all the companies of the industry in a country like inflation, market interest rates, war, etc.

  1. Return:

If there is a risk than definitely there must be some return against that risk, which is a logical thing to understand. An investor only takes an additional risk, if the certain additional return is offered against that risk.

  1. Beta:

Beta is the building block of CAPM theory. In the case of a stock market, the inclination of stock to accelerate with the market is called beta.

Capital Asset Pricing Model

Sharpe and Markowitz are professors who had to develop of capital asset pricing model, which is considered to an important theory in the risk & return portion. Every rational investor wants to maximize the return on his investment at the lowest possible risk.

The investor diversifies his investments over a number of uncorrelated projects in order to eliminate his company-specific (diversifiable) risk. So, the remaining portion of the risk in the portfolio of the investor is the only market risk that cannot be reduced by diversification.

In the case of a portfolio of stocks, there is an index that reflects the Weighted Average of all the transactions on that stock market. The index is a measure of the relative strength of the stock exchange. In reality, there is no stock exchange that is fully diversified.

In CAPM Model, it is assumed that the beta of the market is equal to +1. There are betas of different stocks of a company that are published by rating agencies and stock brokerages. These individual stock betas are compared with the market beta of the stock exchange.

Example:

Suppose in the New York stock exchange there is a trading of stocks of different companies. If the beta of a share A is equal to +1.0, then this means that the share is exactly as risky as the market is. In other words, if the market index, that is 100, goes up to 5% after one year, then the stock A’s beta also goes up to 5% based on the historical data.

If beta of a stock B is +2, then the stock B is double risky as the beta of the New York stock exchange.

If a stock has a beta of -1, then this stock is as much risk as to the market of the stock exchange, But in the opposite direction. In other words, if the stock exchange goes up by 5% in a year then the stock goes down by 5%.

If a stock of beta E is +0.5, then this stock is half as risky as the market of the stock exchange.

The formula of the Beta of a Stock:

In a stock exchange, there is some risk of the market that is indicated through the movements in the index of the stock exchange.  There is also a stock X whose price also changes from one year to another. The movement in the value of a stock relative to the market index is ascertained from one year to another.

Capital Asset Pricing Model Graph

Capital Asset Pricing Model

Capital Asset Pricing Model in Detail

The above graph shows the beta of the stock X in a stock exchange of index 100. The value of the stock X is shown as expected return (rA) on the y-axis whereas the market price is also represented as expected return (rM), but on the x-axis.

The risk-free rate of return is treated as the starting point to measure the movement in the value of both the individual stock X and the market price of the stock exchange (Index). There are points on the graph that shows the relative movement of stock X each year.

The best line of linear regression is made to fit in the graph in order to that passes through these points. If a slope is drawn on the two points of the regression line, then this slope gives the relative risk of the stock X to the overall stock market which is called the beta coefficient.

The formula of the beta coefficient of stock X is given below.

Beta = Slope = ΔY/ ΔX

= %rA /  %rM

= (rA* – rRF) / (rA* – rRF)

In the light of above formula, the coefficient beta is defined as the difference between the expected rate of return of Stock X and the risk-free rate of return whole divided by the difference of market rate of return and the risk-free rate of return.

Portfolio Beta of CAPM:

01- For the calculation of stock beta, there are two ways that are as follows.

The first method is similar to the above least square method of stock beta. On the basis of historical data, the movements in the portfolio returns and market returns are shown on the graph on the x-axis and y-axis respectively. After fitting a regression line through the points, the slope of the line gives the portfolio beta.

02- In the second method, the published stock betas of the individual stocks in a portfolio are averaged on the weighted average basis to give the portfolio beta of all the stocks. Numerically

β(P) = XA βA + XB βB + XC βC +  … β

If you like my article, please comment below and share the link with others. 

Author at Business Study Notes
Richard DanielsAuthor at Business Study Notes

Hello everyone! This is Richard Daniels, a full-time passionate researcher & blogger. He holds a Ph.D. degree in Economics. He loves to write about economics, e-commerce, and business-related topics for students to assist them in their studies. That's the sole purpose of Business Study Notes.
Love my efforts? Don't forget to share this blog.

Related Posts:

  • Risk and Return
    Risk and Return
  • Risk and Return Analysis in Financial Management
    Risk and Return Analysis in Financial Management
  • What is the Process of Motivation? Explain in detail
    What is the Process of Motivation? Explain in detail
  • Markowitz Portfolio Theory Calculation – Complete Guide to…
    Markowitz Portfolio Theory Calculation – Complete Guide to MPT
  • Modigliani and Miller Theory
    Modigliani and Miller Theory

Filed Under: Finance, Financial Management Tagged With: capital asset pricing model definition, capital asset pricing model explained, Capital Asset Pricing Model Graph, CAPM Model, Sharp and Markowitz Model, Sharp and Markowitz theory of capm, Sharpe and Markowitz theory of CAPM

Related Posts

System-Views-of-Management-image

System Views of Management

System Views System views of management associates with the Management division of the organization and it assumes that all of the organizations are … [Read More...]

Leadership Theories

Situational Leadership Theories

Situational Leadership Theories Situational model of leadership is a factor that emphasizes the behavior of the leaders regarding different situations. … [Read More...]

Behavioral Leadership Model

Behavioral Leadership Model

Leadership  Leadership is the most critical and complex responsibility across any organization. It is because the leadership requires to be realistic, … [Read More...]

career development process in hrm

Career Development Process

Career Development Process Today's career development process has become a threat for students, especially a question that may stun many students who have … [Read More...]

Strategic leadership

Strategic Leadership Model

Strategic Leadership Model The strategic leadership model is basically the study of the leadership style. It describes the ways of modernizing an … [Read More...]

Types of Managerial Decision Making

Types of Managerial Decision Making

Managerial Decision Making Decision Making is an art of selection of one feasible alternative decision from many. Therefore types of managerial decision … [Read More...]

Quantitative-management-approach

Quantitative Management Approach

Quantitative Management Approach The quantitative management approach is used to enhance decision making power by using quantitative tools. As well as … [Read More...]

Effective-business-messages-image

Effective Business Messages

Effective Business Messages The process through which business messages are effectively prepared that have the potential to create desired results from … [Read More...]

Search the Site

ADVERTISEMENT

Business Study Notes

Business Study Notes is all about business studies or business education. Visit us to find here free business notes of all the subjects of B.com, M.com, BBA & MBA online.

Disclaimer

All the images and videos present on the Business Study Notes are not owned by us, if you found anything under copyrights, please Contact Us, we will remove it ASAP.

Categories

© Copyright 2023 Business Study Notes. All rights reserved. Privacy Policy, Sitemap.  
DMCA
PROTECTED