capital asset pricing model
theory about relationship between cost and expected return a model of the market used to assess the cost of capital for a company based on the rate of return on its assets.
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 is:
Risk-free rate + (Market return − Risk-free rate) × Beta value = Expected return
The 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 US 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, 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 be:
4% + (11% − 4%) × 1.8 = 16.6% expected return
What the results tell the club is that, given the risk, XYZ Software 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.
Related definitions of "capital asset pricing model"
- Abbr CAPM