BNET Business Dictionary
Business Definition for: Capital Asset Pricing Model
- a model of the market used to assess the cost of capital for a company based on the rate of return on its assets.
Example: The capital asset pricing model holds that the expected return on a security or portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat a theoretical required return, the investment should not be undertaken. The formula used for the model isRisk-free rate + (Market return â€" Risk-free rate) x Beta value = Expected returnThe risk-free rate is the quoted rate on an asset that has virtually no risk. In practice, it is the rate quoted for 90-day U.S. Treasury bills. The market return is the percentage return expected of the overall market, typically a published index such as Standard & Poor's. The beta value is a figure that measures the volatility of a security or portfolio of securities compared with the market as a whole. A beta of 1, for example, indicates that a security's price will move with the market. A beta greater than 1 indicates higher volatility, while a beta less than 1 indicates less volatility.
Say, for instance, that the current risk-free rate is 4%, and the S&P 500 index is expected to return 11% next year. An investment club is interested in determining next year's return for XYZ Software Ltd., a prospective investment. The club has determined that the company's beta value is 1.8. The overall stock market always has a beta of 1, so XYZ Software's beta of 1.8 signals that it is a more risky investment than the overall market represents. This added risk means that the club should expect a higher rate of return than the 11% for the S&P 500. The CAPM calculation, then, would be4% + (11% â€" 4%) x 1.8 = 16.6% Expected ReturnWhat the results tell the club is that, given the risk, XYZ Software Ltd. has a required rate of return of 16.6%, or the minimum return that an investment in XYZ should generate. If the investment club does not think that XYZ will produce that kind of return, it should probably consider investing in a different company.
- a theory which predicts that the expected risk premium for an individual stock will be proportional to its beta, such that expected risk premium on a stock = beta × expected risk premium in the market. Risk premium is defined as the expected incremental return for making a risky investment rather than a safe one.
Additional Resources
- The Capital Asset Pricing Model: Theory and Evidence
- The capital asset pricing model CAPM of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990). Before their breakthrough, there were no asset pricing models built from first principles about the nature of tastes and investment...
- White papers 2003-08-01
- The Capital Asset Pricing Model and the Three Actor Model of Fama and French Revisited in the Case of France
- This study tries to test the three factor model of Fama and French and the Capital Asset Pricing Model on the French Stock Market. It uses returns on the six Fama and French portfolios sorted by size and book to market ratio. The sample is taken from July 1976 to...
- White papers 2002-06-20
- Existence of Equilibrium and Zero-Beta Pricing Formula in the Capital Asset Pricing Model With Heterogeneous Beliefs
- The paper studies a mean-variance capital asset pricing model CAPM in which investors have different probability beliefs about assets returns and different attitudes towards risk, all assets are risky, short-selling is allowed and satiation is possible. First, it proves that there exists a competitive equilibrium in the model under a...
- White papers 2003-06-03
- Capital Asset Pricing Model Integrating both Firm and Market
- This paper proposes a theoretical framework to incorporate a firm's intrinsic value and market-trading value into asset pricing model. It shows that asset return can be decomposed into two components. The first component, called the firm factor, is related to the output of a firm and is proportional to return...
- White papers 2003-07-01
- Trading Volume: Implications of an Intertemporal Capital Asset Pricing Model
- This paper deals with an intertemporal capital asset pricing model with multiple assets and heterogeneous investors, and explores its implications for the behavior of trading volume and asset returns. Assets contain two types of risks: market risk and the risk of changing market conditions. It shows that investors trade only...
- White papers 2002-11-11
- The Game-Theoretic Capital Asset Pricing Model
- The paper presents the derivation of a capital asset pricing model from an efficient market hypothesis, with no assumptions about the beliefs or preferences of investors. The efficient market hypothesis says that a speculator with limited means cannot beat a particular index by a substantial factor. The model reveals that...
- White papers 2002-03-03
- Rethinking CAPM; Sharpe supports less complex simulation as a way to overcome the flaws of mean-variance analysis.(Portfolio Strategies)(Capital Asset Pricing Model )
- Byline: Joel Chernoff William F. Sharpe says his pioneering work on the Capital Asset Pricing Model is ready for a makeover. The 42-year-old model - which earned Mr. Sharpe a Nobel Memorial Prize in economics in 1990 - is being revamped because...
- Research articles 2006-10-02
- An Equilibrium Model Of Asset Pricing And Moral Hazard
- Using the Capital Asset Pricing Model CAPM as a benchmark, this article develops an integrated model of asset pricing and moral hazard. The expected excess returns for risky assets, optimal contracts for managers agents that involve relative performance, and equilibrium asset prices are explicitly characterized. It is shown that the...
- White papers 2003-08-10
- Asset Pricing With Liquidity Risk
- This paper solves explicitly an equilibrium asset-pricing model with liquidity risk - the risk arising from unpredictable changes in liquidity over time. In our liquidity-adjusted capital asset pricing model, a security's required return depends on its expected liquidity as well as on the covariance of its own return and liquidity...
- White papers 2004-09-01
- A General-Equilibrium Asset-Pricing Approach to the Measurement of Nominal and Real Bank Output
- This paper addresses the proper measurement of financial service output that is not priced explicitly. It shows how to impute nominal service output from financial intermediaries' interest income and how to construct price indices for those financial services. The present an optimizing model with financial intermediaries, that provide financial services...
- White papers 2004-10-15
- A Portfolio Selection and Capital Asset Pricing Model
- The aim of this paper is to improve the characterization of a capital market within the CAPM without losing its simplicity and explanatory power. To highlight the peculiarities of the model, the main steps in the development of the standard CAPM are briefly reviewed. The standard CAPM is extended so...
- White papers 2002-02-06
- Pricing for Systematic Risk
- The financial methods have emerged as the dominant approach for establishing insurance profit loadings. Financial theory suggests that prices should reflect systematic risk only, with no reward for diversifiable risk. This principle is applied to the pricing of insurance exposures actively traded in a secondary market. The resulting Systematic Risk...
- White papers 2004-08-12
- Ennisknupp Capital Markets Modeling Assumptions
- Asset allocation modeling requires three types of inputs: estimates of expected return, volatility, and correlation among asset classes. EnnisKnupp's capital markets model uses a theoretical, global capital asset pricing model Global CAPM methodology to obtain expected returns for individual asset classes, rather than relying on historical results or arbitrary estimates....
- White papers 2003-01-01
- Fama-French Three Factor Model - I
- This article describes Fama-French Three Factor Model, which is a highly useful tool for understanding portfolio performance, measuring the impact of active management, portfolio construction, and estimating future returns. The Three Factor Model has replaced Capital Asset Pricing Model (CAP-M) as the most widely accepted explanation of stock prices taken...
- White papers 2003-01-01
- Pricing the Global Industry Portfolios
- The paper investigates the ability of several international asset pricing models to price the returns on 36 FTSE global industry portfolios. The models are the international capital asset pricing model ICAPM the ICAPM with exchange risks, and global two-factor and three-factor Fama-French models. While all of the models can correctly...
- White papers 2002-11-01
- Executive Stock and Option Valuation in a Two State-Variable Framework: Allowing Optimal Investment of Outside Wealth in the Risk Free Asset and the Market Portfolio
- This paper provides a two state-variable discrete-time executive option valuation model that allows optimal investment of executive's outside wealth in the risk free asset and the market portfolio. The model adopts outside investment only in the risk free asset. The model is consistent with portfolio theory and the capital asset...
- White papers 2004-09-01
- Asset Allocation Math, Methods and Mistakes
- Over the last ten years, some very basic premises about asset allocation have been forgotten. The roots of asset allocation theory started with a piece of work called "The Capital Asset Pricing Model" (CAPM-beta as a measure of risk) and evolved into "Modern Portfolio Theory" (MPT- Standard deviation as a...
- White papers 2001-06-01
- Developing a Capital Asset Pricing Model
- CAPM describes the relationship between risk and expected return for an individual portfolio or security. Its underlying theory has prompted lively discussion about what "risk" actually means, asserting that only "systematic" (non-diversified) risk brings real reward to investors. Systematic risk is unavoidable, market-oriented risk that cannot be averaged out through...
- Articles 2007-10-12
- The Federal Reserve Bank's Imputed Cost of Equity Capital
- This paper proposes a new approach for calculating the cost of equity capital used in the PSAF. The proposed approach is based on a simple average of three methods as applied to a peer group of bank holding companies. The three methods estimate the cost of equity capital from three...
- White papers 2001-01-10
- A newcomer on the catwalk. (Goldman Sachs' international capital-asset pricing model)
- ASSET allocation is an uneasy marriage between investment and technology. Computer models should be invaluable in helping fund managers decide how to invest. In practice, not so. Their advice is too often eccentric, unusable or just wrong. ASSET allocation is an uneasy marriage between...
- Research articles 1991-03-02
