What is Capital Asset Pricing Model or CAPM?

The Capital Asset Pricing Model or CAPM is the industry standard for pricing the future market return of an investment security. As an arbitrageur, you should always be well aware of the way bankers value their assets and what rate of return they expect from them.

The value of the Formula CAPM is that internally accounts for the many of the market risks that investors are exposed to. Such as the systematic risks of declining markets because all correlations (beta) goes to one (1). The framework of the return of investment of the Capital Asset Pricing Model equation is that the individual investor can compare the future performance of a single equity name or fund versus the risk free return of treasury bills (^TNX).

What is Capital Asset Pricing Model/

Risk Free Rate vs. Market Return

William Sharpe formulated the equation to compare the risk relationship of expected market returns of a diversified portfolio; which is the fundamental base for Arbitrage Pricing Theory APT. But we are only going to focus on single names stocks that pay a high dividend yield. In order to explain these changes we are going to apply the commonly used modern portfolio theory formula.

Capital Asset Pricing Model Formula

First Step: you have to begin with the risk-free rate (Rf) the yield of the ten years government bond. Now in the Arbitrageur Capital Asset Pricing Model instead of using the coupon rate of the bond we are going to use the effective saving rate which is calculated by subtracting (^TNX consumer price index CPI).

Second Step: input the Market Beta (B)  beta which assess the stock market risk correlation. It measures the relative volatility of how stocks may go “bullish”, a positive +1 or higher correlation versus “bearish” a negative -1 or lower correlation towards the whole flow of the S&P 500 index. But since we are going to arbitrage with a single name security we are going to use the beta of the specific stock.

Third Step: research the expected market return (Erm). Market investing exposes you to the risk of losing your original capital. Reason why we must demand a higher compensation for our exposure, a “risk premium”. But in the new application we are going to use the yield of our fund as the risk premium value.

The Arbitrageur System Capital Asset Pricing Model Formula

The Bottom Line

As part of your investing process you should always account for market risk. Using the Capital Asset Pricing Model can give you an advantage at the time of making your buying and selling decisions because it gives you the opportunity of predicting your future return on investment (ROI).

Case Study Time

Develop a spreadsheet where you can calculate the expected market return for the biggest holding in one’s portfolio; using the new application of the Arbitrageur System for Capital Asset Pricing (ASCAP).