Introduction of CAPM

Jack L. Treynor has made the model named Capital Asset pricing. Its short form is CAPM. He has lot of experience in investment decisions and analysis. Capital Asset pricing model is relating to Arbitrate Pricing theory ( APT).

Definition of CAPM

With capital asset pricing, we can easily calculate appropriate rate of return of asset. It is different from normal rate of return. Because, appropriate rate of return will be at that point where there is no risk. William Sharpe researched in this model who received Nobel memorial prize in economics for his contribution in financial economics.

Explanation of CAPM

In CAPM, we make security market line. After making this line on graph paper, we calculate the point where, we will receive risk free rate of return.

Formula of Calculating CAPM =

Expected excess return on the capital asset - risk free rate of interest / Beta coefficient

Or

we can say it expected rate of return / required rate of return

Beta Coefficient

= Expected excess return of the market/ Variance of expected excess return of the market

Aims of CAPM

1. Main aim of this model is to calculate price of an asset correctly. This model is very useful to create the relationship between risk and discount rate.

2. This model can be used for calculating the efficient frontier region on the graph paper where investor will receive return at lowest level of risk.

3. It is also used by investor for selecting risk free stock. Suppose, if a company want to invest in XYZ company but through CAPM, you know that you should get at least 15% from your investment risk free. If you think that company will produce same or more return than 15%, then you would probably consider investing in Xyz Company. .

Name