Capital Asset Pricing Model Calculator
Understanding the Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a fundamental model in finance that determines the appropriate required rate of return for a financial asset or investment. This rate of return accounts for its inherent risk level.
CAPM distinguishes the total risk associated with an asset into two distinct categories. One is the "market risk" or the undiversifiable risk, denoted by "beta", which measures the fluctuations of an asset value in response to changes in the aggregate value of all assets in the economy. The other is the "specific risk" or diversifiable risk, attributed to the uniqueness of an asset and its immediate surroundings.
The core principle of CAPM is that the required rate of return on an asset should depend on its market risk or "beta". A higher level of systematic risk implies a higher expected return for the asset.
Using the Capital Asset Pricing Model Calculator
To utilise the CAPM, you need the following inputs:
Risk-free interest rate (Rf): This rate is typically assessed as the yield on a long-term government bond in the country where the project is based.
Broad market return (Rm): The overall return from the market.
Beta (β): The parameter indicating the market risk.
The CAPM formula is as follows:
R = Rf + β × (Rm - Rf),
WhereR is the expected rate of return of an asset or investment.
A Practical Example of Using A CAPM Calculator
Let's imagine you're considering investing in a particular stock.
Assume the risk-free rate (Rf) is 2.4% (yield for the 3-month US Treasury Bill). You've identified a beta (β) of 0.47 for Walmart Inc, meaning that Walmart's return's sensitivity to changes in the total value of assets is around half of the market average. Finally, the market return (Rm) is 10% (the long-term average return of the S&P 500).
Substituting these values into the CAPM formula, the calculation is as follows:
R = 2.4 + 0.47 × (10 - 2.4),
Solving for R gives us an expected return of approximately 6%. This suggests that investing in Walmart stock would yield an estimated return of 6% for the level of risk undertaken.