CAPM (Capital Asset Pricing Model EXPLAINED) — Transcript

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1. 0:12What does CAPM stand for? The acronym CAPM stands for C, Capital, A, Asset,
2. 0:21P, Pricing and M, Model. What is the CAPM?
3. 0:28The Capital Asset Pricing Model, or  CAPM, identifies the relationship between
4. 0:33systematic risk and the assured return  of assets like stocks. In other words,
5. 0:38it basically shows you how much risk you have  to take to get a certain amount of return.
6. 0:44CAPM is a great tool to price risk securities  and find the expected returns of an asset based
7. 0:49on the risk and cost of capital. The formula for  calculating the CAPM is: ERi = Rf + βi (ERm - Rf).
8. 1:02ERi equals expected return of  investment, Rf equals risk-free rate,
9. 1:08βi equals beta of the investment and (ERm  - Rf) equals market risk premium.
10. 1:14How does CAPM work? The beta coefficient of an
11. 1:19investment measures a stock’s volatility compared  to the systematic risk of the entire market.
12. 1:24The systematic risk is the non-removable risk of  the stock market. The beta of an investment is the
13. 1:30measure of how much risk the investment will bring  to a portfolio that resembles the stock market.
14. 1:36Theoretically, stocks with a  beta coefficient less than 1
15. 1:40have smaller volatility than the market. Stocks  greater than 1 will have a higher volatility than
16. 1:45the market. Here are a few examples: a beta  coefficient of 1 means that the stock moves
17. 1:51perfectly with the stock market. However,  if the beta coefficient of a stock is 1.5,
18. 1:57it means that the stock price will rise by 15%  if the stock market moves by 10%. And vice versa.
19. 2:05A negative beta coefficient means that the stock  and stock market moves in opposite directions.
20. 2:10So for example, if the beta coefficient is -1,  the stock will fall 10% if the stock market is
21. 2:17up by 10%. A stock’s beta will be multiplied  by the market risk premium, which is the return
22. 2:23expected from the market. The risk-free rate is  then added to the product of the stocks beta and
23. 2:28the market risk premium. Finally, the investor  can get the required return or discount rate
24. 2:33and use it to find the value of an asset. The  ultimate goal for CAPM is to determine the true
25. 2:39value of a stock. After determining the true value  of a stock, investors can determine if the stock
26. 2:44is overvalued or undervalued. Example of the CAPM
27. 2:49Let’s say that there is an investor who is  deciding to buy a stock worth $100 per share.
28. 2:55The stock pays a 5% dividend. However, the  stock’s beta compared to the market is 1.4,
29. 3:02which means it is riskier than a market portfolio.  The risk-free rate is 2% and the investor expects
30. 3:08the market to rise 10% in value every year. The  expected return of the stock based on the CAPM
31. 3:15formula would then be 16.2: 16.2 = 5% + 1.4 x (10% - 2%)
32. 3:24Problems with the CAPM There are several aspects of CAPM
33. 3:28that don't actually work in the regular world.  By including beta into the formula, CAPM assumes
34. 3:34that risk can be measured by a stock’s price  volatility . However, price movements in both
35. 3:39directions are not equally risky and stock  returns and risk are not normally distributed.
36. 3:45The CAPM also assumes that the risk-free rate  will remain the same over a period of time.
37. 3:51An increase in the risk-free rate also increases  the cost of the capital used in the investment
38. 3:56and could make a stock look overvalued. The most  serious problem with CAPM is the assumption that
39. 4:02future cash flow can be estimated for the  discounting process. However, if an investor
40. 4:08can really estimate the future return of a stock,  then the entire CAPM is not even necessary.
41. 4:15CAPM and the Efficient Frontier Using CAPM can help investors manage risk
42. 4:21in their portfolio. If an investor is able to  use the CAPM to perfectly optimize a portfolio’
43. 4:27s profit compared to risk, it would happen  on a curve called the efficient frontier.
44. 4:33The efficient frontier can be used to build a  portfolio that has the most return with the least
45. 4:39risk. The efficient frontier is generally the same  as the CAPM and is only a theory. If a portfolio
46. 4:47existed on the efficient frontier curve, it  would make the most return for its level of risk.
47. 4:54It’s impossible to actually know if a portfolio  is on the efficient frontier because we cannot
48. 4:59predict future changes in the stock market.
49. 5:04Key Takeaways
50. 5:09The CAPM uses the rules of the Modern  Portfolio Theory to determine if a
51. 5:13security is fairly valued. It relies on investor behaviors,
52. 5:17risk and return, and market fundamentals  that don’t match reality.
53. 5:20The underlying concepts of the  CAPM and efficient frontier can
54. 5:24aid investors to understand the relationship  between expected risk and reward by looking
55. 5:28at the total amount of risk and return achieved  with adding a security to their portfolio.
56. 5:34CAPM states that to generate higher return,  you will need to take on more risk.
57. 5:42Thank you for watching Animated Finance. Comment  below on whether you believe in the CAPM!