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 β 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% β 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 Γ 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
- 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
- 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
- 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
- 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
- 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
- A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation or Cross-sectional Heterogeneity?
- This paper studies the asset pricing implications of a parsimonious two-agent macroeconomic model with two key features: limited participation in the stock market and heterogeneity in the elasticity of inter-temporal substitution. The parameter values for the model are taken from the business cycle literature and, in particular, are not calibrated...
- White papers 2003-09-01
- 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
- Time Orientation and Asset Prices
- The paper analyzes a general-equilibrium asset pricing model where a small subset of the consumers/investors has a short-run "urge to save". That is, their attitudes toward consumption in the long run is a standard one they do place zero weight on consumption far enough out in the future but their...
- White papers 2001-04-01
- 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
- 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 Perception Of Time, Risk And Return During Periods Of Speculation
- This paper has derived the consequences of two hypotheses for the relationship between risk and return. The first hypothesis states that assets with the same risk must have the same expected return. From this, one derives the well-known invariance of the Sharpe ratio for uncorrelated stocks, as well as the...
- White papers 2002-01-10
- Stock Return Predictability and Asset Pricing Models
- Asset pricing models imply restrictions on stock return predictability. This paper evaluates the economic significance of deviations from such restrictions using a Bayesian optimizing framework. In that framework, an investor uses the sample evidence to update various degrees of skeptical views about models pricing abilities, and derives asset allocation based...
- White papers 2002-05-23
- CAPM Calculator
- This Capital Asset Pricing Model calculator CAPM can help the investor figure out the expected return on a capital asset at a given risk level. The CAPM is a common stock valuation tool used by investors and this calculator provides both the expected return on the capital asset as well...
- Tools & templates 2008-01-01
- An Exact Bayes Test of Asset Pricing with Application to International Markets
- This paper develops and implements an exact finite-sample test of asset pricing models with conditioning information. The strength of its approach is that it allows multiple conditional asset pricing specifications, whether nested or non-nested, to be tested and compared simultaneously. It can also incorporate investor uncertainty about the correct asset...
- White papers 2002-07-08
- Learning about Beta: A New Look at CAPM Tests
- This paper develops an equilibrium model of learning about time-varying beta. In the model, the capital asset pricing model CAPM works for investors' probability distribution. However, mispricing can be observed if econometricians estimate betas without accounting for the investors' learning process. The empirical implication for asset-pricing tests is that the...
- White papers 2004-09-01
- The Growth Optimal Asset
- The purpose of this paper is to derive an asset pricing model based on a growth optimal portfolio, in a market where there are multiple regimes, and to estimate the risk premiums of J-REITs based on this theory. In an asset pricing model employing a regime switching model, two equations...
- White papers 2004-08-26
- An Option Pricing Approach to Asset Sale
- This paper presents a model of asset sale under uncertainty and derives an optimal scrapping rule. It shows that under certain conditions an asset should be scrapped when its operating profit first reaches a critical level. A testable equation based on the model is suggested. The model may be applied...
- White papers 2000-07-01
- Currency Risk in Emerging Equity Markets
- The paper develops an international capital asset pricing model, which includes foreign currency risk, and examines the impact of capital market liberalisation on the pricing of risks. It applies the model to data from Pacific Basin financial markets and finds substantial evidence that not only currency risk is priced in...
- White papers 2002-09-05
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