INTRODUCTION
Everything in life must carry some meaning so do CAPM. We have simple understanding of fair value, high risk and low risk decisions.
Imagine a basic scenario, early in the morning you found you dog to be very ill. Now you have to go to a medical shop to buy a particular medicine prescribed by pet-doctor over a call.
|
Shops |
Discount |
Distance from home |
Probab. that Medicine is available |
|
A |
0% |
1km |
6/10 |
|
B |
15% |
2km |
3/10 |
|
C |
30% |
3km |
1/10 |
DECIDE WHERE WOULD YOU GO?
Shop A is near and probability of getting the medicine is high but wait you wont get any discount
Shop B is little far Probability of getting the medicine is way lower and you get a fair discount.
Shop C is far away against all the odds thers’s only one benefit that is higher discount.
Moreover, your dog is very ill keeping that in mind take the decision…
So as a normal human (I think you are) most of us would choose A (pet lovers) or B (wanna save some cash for snacks) very little (stone-hearted ;) ) would take the risk of going to Shop C.
In same manner CAPM allows us to take decisions for investing in any ASSET by evaluating the risk associated with returns.
Let the dog get its medicine (none of our business) lets learn about CAPM.
PURPOSE
The purpose of the Capital Asset Pricing Model (CAPM) in finance is to establish a relationship between the expected return of an asset and its risk, helping investors make informed decisions. Specifically, CAPM serves several key functions:
- Risk Assessment: CAPM calculates the risk associated with any asset, using its BETA. Allowing us to understand the sensitivity of the asset with respect to market.
- Expected Return Calculation: Using the formula which CAPM suggests we can calculate the returns that are expected over an asset.
- Portfolio Optimization: CAPM allows us to balance the risk and return using which we can create an optimised portfolio.
- Investment Valuation: It helps us in determining the fair value of any asset taking into consideration the risk associated with it.
- Performance Benchmarking: It helps us to compare an real world portfolio returns with the expected returns and hence create a bench mark for the same.
TERMS
Expected Returns
Before investing in anything we ask only one question what can I get out of it? Is the Return on Investment is worth it with its current price?(considering the risk involved). It represents the average return an investor can expect to earn based on historical data, market conditions, and the asset's risk profile. Expected return is crucial for investors because it helps them evaluate whether an investment aligns with their financial goals and risk tolerance.
BETA
Beta is a measure of an asset's volatility relative to the overall market. It indicates how much an asset's price is expected to change in response to changes in the market.
· A beta of 1 means the asset's price moves in line with the market;
· A beta greater than 1 suggests higher volatility (the asset is more sensitive to market movements),
· A beta less than 1 indicates lower volatility (the asset is less sensitive). For example, a stock with a beta of 1.5 is expected to rise or fall by 1.5% for every 1% change in the market.
Beta is essential in CAPM because it helps investors understand the level of risk associated with an asset compared to the market, enabling better investment decisions and portfolio management.
Risk Free Rate
The risk-free rate is the theoretical return on an investment with zero risk, typically represented by government bonds, such as U.S. Treasury securities, Now a days the savings account of government banks in India and Gold-silver assets are also considered to be Least risk investment where the risk involved is nearly zero.
CALCULATIONS
FORMULA
EXPECTED RETURN=RISK-FREE RATE+ BETA x (MARKET RATE-RISK
FREE RATE)
REAL LIFE INVESTMENT SENARIO
(This time I will try not to hurt any dog lovers)
Consider Ramu wants to invest in Some stock QWERTY considering the risk free rate he is receiving by keeping his money in SBI savings account to be 2 % and QWERTY’s historical performance shows she can expect a return of 10% and the history also shows the BETA to be 1.5.
RISK FREE RATE= 2 % = 0.02
MARKET RETURN= 10%= 0.1
BETA= 1.5
EXPECTED RETURN = 0.02+ 1.5 x (0.1-0.02) = 0.14 = 14%
He did not keep his money in SA of bank why we use its rate here?
The CAPM formula is designed to provide a way to estimate the expected return on an asset based on its risk relative to the market, even if the investor doesn't actually invest in a risk-free asset.
Where is the risk?
It lies in the BETA
If the market crashes so will your money ; even at a faster rate !