Calculating Expected Return Using CAPM
We will cover following topics
Introduction
In this chapter, we delve into the practical application of the Capital Asset Pricing Model (CAPM) in estimating the expected return on an asset. CAPM plays a crucial role in modern portfolio theory by providing a framework to assess the risk and return trade-off for individual assets. By understanding how to calculate the expected return using CAPM, investors can make more informed decisions about potential investments and portfolio allocations.
Calculating Expected Return Using CAPM
The CAPM formula helps investors determine the expected return on an asset based on its systematic risk, as measured by its beta, and the market risk premium. The calculated expected return represents the compensation an investor demands for bearing the systematic risk associated with the asset. If the expected return calculated using CAPM is higher than the risk-free rate, the asset is considered to be offering a risk premium for its level of risk.
The formula for the expected return (E(R)) using CAPM is:
$$E(R)=R_f+ \beta \times\ (E(R_m)-R_f)$$
Where:
- $E(R)=$ Expected Return on the Asset
- $R_f=$ Risk-Free Rate
- $\beta=$ Beta of the Asset
- $E(R_m)=$ Expected Market Return
Example: Let’s say the risk-free rate $(R_f)$ is 3%, the beta ($\beta$) of the asset is 1.2, and the expected market return $(E(R_m))$ is 8%. Using the CAPM formula:
$$E(R)=0.03+1.2 \times (0.08-0.03)=0.09$$
So, the expected return on the asset is 9%.
Conclusion
By applying the CAPM model, investors can estimate the expected return on an asset, which serves as a critical input for making investment decisions. This approach provides a systematic way to assess an asset’s potential returns relative to its risk, facilitating better portfolio diversification and risk management strategies. The CAPM’s contribution to estimating expected returns is a cornerstone of modern portfolio theory and aids investors in aligning their portfolios with their risk and return objectives.