Instructions: You can use this CAPM Calculator to estimate the expected return using the Capital Asset Pricing model, providing the risk free return (\(r_f\)), beta (\beta) and market return (\(r_M\)):
The Capital Asset Pricing Model (CAPM) is an extremely popular model to estimate the expected return of a firm considering the market conditions, the risk free level of return and the risk of a company.
What is the formula for the CAPM model?
The CAPM formula is very intuitive. It indicates that the expected return an investor should expect from a specific firm corresponds the risk free return, plus an amount that is proportional to the market premium. The proportionality constant is simply the beta of the company.
Mathematically, this is written as follows:\[ r_s = r_f + \beta (r_M - r_f)\]
where \(r_f\) is the risk-free return (usual the government bonds), \(\beta\) is the beta of the company (measuring its risk with respect to the market) and \(r_M - r_f\) is the market risk premium.
Example of CAPM calculation?
Assume you have a stock that has a beta of 1.5, and that the risk-free return is 3%. Also, the return of the market is 8%. What is the expected return of the firm?
We have to use the CAPM model formula:\[ r_s = r_f + \beta (r_M - r_f)\] \[ = 3% + 1.5 \times (8% - 3%)\] \[ = 3% + 1.5 \times 5%\] \[ = 3% + 7.5%\] \[ = 10.5%\]
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