Capital Asset Pricing Model

Capital Asset Pricing Model is a model used to calculate the rate of return of a risky asset (Berkman, 32-35). It is often used to determine the price of a risk undertaken. It considers the assets rate of return for the risk-free security, market’s expected rate of return and beta of the asset. Thus, when calculating CAPM we use the following formulae; Ra=rrf + βa (rm- rrf) Where: rrf= rate of return for a risk-free security. It mostly uses treasury bills and bonds as the substitution for the risk-free rate. βa=beta of an asset. This can be based on the analysis undertaken. rm= broad market expected rate of return. This can be based on past returns or projected future returns. Generally, the model is used to determine the fair value of an investment (Bouaziz and Breton, 26). This is compared with its market price and this one forms a base. If price estimate is higher than the market, you consider the asset a bargain. If price estimate is lower, you consider the asset as overvalued. Where beta is more than one, the asset is set to be riskier. If beta is less than one, the asset is said to be less risky. A riskier asset will have a higher beta and thus will be discounted at a higher rate. A less risky asset will have a lower beta which will insinuate a lower discount rate. In the market, most investors will require a higher return and thus will likely go for a risky asset.