CAPM
E(R) = Rf + β × (Rm - Rf)
The Capital Asset Pricing Model estimates the expected return on an asset based on its systematic risk (beta).
Variables
Required return on the asset
Return on government bonds
Sensitivity to market movements
Excess return of market over risk-free rate
Example Calculation
Scenario
Risk-free rate is 3%, market return is 10%, and the stock's beta is 1.3.
Given Data
Calculation
E(R) = 0.03 + 1.3 × (0.10 - 0.03) = 0.03 + 0.091 = 0.121
Result
12.1%
Interpretation
Investors require 12.1% return to compensate for the stock's market risk.
When to Use This Formula
- ✓Estimating cost of equity for WACC
- ✓Evaluating if a stock is fairly priced
- ✓Security Market Line analysis
Common Mistakes
- ✗Using total risk instead of beta
- ✗Applying a historical market premium that does not match the forecast period
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FAQs
Common questions about this formula
It is a useful approximation. Critics note that beta alone may not capture all risk factors, leading to multi-factor models.
A negative beta means the asset moves opposite to the market. CAPM would produce an expected return below the risk-free rate. Gold and some hedging instruments can have negative betas, making them valuable for portfolio diversification.