Capital Asset Pricing Model is a tool to calculate the expected rate of return on an asset. There are three main factors of this model:
- Risk-Free Return
- Market Premium
- Sensitivity to market also known as Beta
Risk free return is the rate of return expected to be generated with zero risk. Usually, the government treasury bills are considered risk-free assets and the rate of return on treasury bills is taken as risk-free return.
Market premium is the difference between the market rate of return and risk-free return. It is the rate of return that an asset may earn over and above the risk-free rate. For example, if the risk-free rate is 4% and an asset can earn 7% in the market, the market premium is 3% (7% – 4%).
Sensitivity to the market is the change in the price of an asset with the change in the market benchmark or the relative index. This is also known as the beta of the assets.
Considering all these components we can calculate the expected rate of return with the help of the following formula:
Expected rate of return = Risk free rate + (Market rate – Risk free rate) x Beta
Example:
An asset has a beta of 1.5 in the market. The market rate of return at the moment is 8%. The yields of treasury bills are 5%. Calculate the expected rate of return as per capital asset pricing mode.
Expected return = Risk free rate + (Market rate of return – Risk free return) x Beta
Expected return = 5% + (8% – 5%) x 1.5
Expected return = 5% + 4.5%
Expected return = 9.5%
Therefore, the expected return of the asset in the given example is 9.5%.
