Required Return

Capital Asset Pricing Model

ALINE APRILLE CAPUCHINO-MENDEZ
What is Capital Asset Pricing Model
• The capital asset pricing model (CAPM) is a model that describes the
relationship between systematic risk and expected return for assets,
particularly stocks.
• CAPM is widely used throughout finance for the pricing of risky
securities, generating expected returns for assets given the risk of
those assets and calculating costs of capital.
Equity and Debt
• In equity investing, the required rate of return is used in
various calculations.
• For example, the dividend discount model uses the RRR to
discount the periodic payments and calculate the value of
the stock. Finding the required rate of return can be done
by using the capital asset pricing model (CAPM).
Required Return On A Stock Has Two Components

• a compensation for the expected loss of purchasing power

• and an extra compensation for bearing risk.
The CAPM will require that you find certain
inputs:

the risk-free rate (RFR),

the stock's beta,

the expected market return.

the market risk premium

• Start with an estimate of the risk-
free rate.

• Next, take the expected market risk premium

for the stock which can have a wide range of
estimates.

• Lastly, you can use the beta of the

stock.
The general idea behind CAPM is that investors
need to be compensated in two ways:

time value of money

risk
Time Value
• The time value of money is represented by the risk-free (rf) rate in the
formula and compensates the investors for placing money in any
investment over a period of time. The risk-free rate is customarily the
yield on government bonds like BSP Treasuries.
Risk
• The other half of the CAPM formula represents risk and calculates the
amount of compensation the investor needs for taking on additional
risk. This is calculated by taking a risk measure (beta) that compares
the returns of the asset to the market over a period of time and to the
market premium (Rm-rf): the return of the market in excess of the
risk-free rate.
The Formula
The standard formula remains the CAPM, which describes the relationship between
risk and expected return of an asset given its risk is as follows:
_ _
Ri= Rf + Ba (Rm – Rf)

Ri =Rf + MRP x βi
Risk-Free Rate + (Beta X Market Risk Premium)
Where:

r f= risk free rate

Ba = Beta of the security

rm = Expected market return

The CAPM says that if we’re going to invest in the
shares of any company we should require return for
two reasons
• One, because we want to be compensated for our expected
loss of purchasing power; that’s the risk-free rate, and, as
the name suggests, it is not related to risk.
• Two, because when we buy equity the return is not
guaranteed and therefore we bear some risk.
 Birth of a Model
The capital asset pricing model was the work of financial economist (and later,
Nobel laureate in economics) William Sharpe, set out in his 1970 book "Portfolio
Theory and Capital Markets." His model starts with the idea that individual
investment contains two types of risk:
• Systematic Risk – These are market risks that cannot be diversified away.
Interest rates, recessions and wars are examples of systematic risks.
• Unsystematic Risk – Also known as "specific risk," this risk is specific to
individual stocks and can be diversified away as the investor increases the
number of stocks in his or her portfolio. In more technical terms, it represents
the component of a stock's return that is not correlated with general market
moves.
CAPM's starting point is the risk-free rate – typically a 10-
year government bond yield. To this is added a premium
that equity investors demand to compensate them for the
extra risk they accept. This equity market premium
consists of the expected return from the market as a
whole less the risk-free rate of return. The equity risk
premium is multiplied by a coefficient that Sharpe called
"beta."
Beta coefficient
Is a statistic which measures the systematic risk of a particular
investment relative to the broad market.
The beta efficient is more than 1 means that the investment carries
more systematic risk than the market and that of less 1 means less
systematic risk that broad market.
Equity Risk Premium
Equals the rate of return on the broad market such as
S&P 500 minus the risk rate. It is an estimate of the
reward the equity investors require to take the
systematic risk inherent in a portfolio of securities
representative of the equity market.
Example
Jollibee Food Corporation (PSEi:JFC) has a beta coefficient of .899. Estimate the cost
of equity if the risk free rate is 3.6 % and return on the broad market index is 2.19%
Solution
CAPM
Ri =Rf + MRP x βi
Risk-Free Rate + (Beta X Market Risk Premium)
Cost equity = risk free rate + beta coefficient x equity premium
Cost equity = risk free rate + beta coefficient x (broad market return – risk free rate)
Cost of equity JFC = 3.6% +(.899)(7.27%)
Cost of equity JFC =10.13573% or 10..14%
Example of Capital Asset Pricing Model
(CAPM)
Using the CAPM model and the following assumptions, we can compute the
expected return for a stock:
• The risk-free rate is 3.6% and the beta (risk measure) of a stock is .899 The
expected market return over the period is 10%, so that means that the market
risk premium is 3.67% (7.27% - 3.6%) after subtracting the risk-free rate from
the expected market return. Plugging in the preceding values into the CAPM
formula above, we get an expected return of 3.42% for the stock:
• = 3.6% + .899 x (7.27%-3.6%)
• =3.6% + .899 x 3.67%
• =3.41810588 or 3.42%
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References
• Analysis of investments and management of portfolio , Brown and Reilly
• The Capital Asset Pricing Model: An Overview
www.investopedia.com/articles/06/capm.asp#ixzz5FzwIAljQ
• The essential financial toolkit, Javier Estrada
• Required Rate Of Return
(RRR) www.investopedia.com/terms/r/requiredrateofreturn.asp#ixzz5GKN4raOv
• www.bsp.gov.ph/statistics/sdds/tbillsdds.htm
• www.stern.nyu.edu/~adamodar/pc/darasets/cntryprem.xls