Capa - Capital Asset Pricing Model

CAPA -capital asset pricing model

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk.

the higher the risk associated with any given stock the higher the required rate of return an investor will demand

the CAPM helps us find what will be the required rate of return for a given stock by using the following formula

Ra= Rf + Beta (Rm - Rf)

Ra = required rate of return for a given stock, say stock "a"

Rf = the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time.

currently the yield for a 10 year US bond is 1.62%

beta - measures the degree of risk associated with a particular stock

the higher the value of BETA the riskier the stock and the higher the rate of return an investor will demand

great - if beta =1 the interpretation is that the stock moves 1:1 with the overall stock market,

if beta is 1.5 this means that if the market moves up/down 1% the stock will fluctuate 1.5% so this is a riskier stock

should beta be 0.5 the opposite would be the case

Rm is simply the average rate of return of the stock market

So suppose we have a stock with a Beta of 1.5 and Rm is 10%, Rf is 1.62% what will be the Ra?

Ra= Rf + Beta (Rm - Rf)

Ra = 1.62 + 1.5(10-1.62)

Ra = 1.62 + 1.5(8.38)

Ra= 1.62 + 12.57

Ra = 14.19

14.19% is the required rate of return for that particular stock

ok - the other question is asking you the following:

Use the CGM to find the current stock price for XYZ. We will call this the theoretical price (Po).

CGM stands for constant growth model. this is a model we use in finance to find value of a particular stock. Stock Valuation is more difficult than Bond Valuation because stocks do not have a finite maturity and the future cash flows, i.e., dividends, are not specified. Therefore, the techniques used for stock valuation must make some assumptions regarding the structure of the dividends.

A constant growth stock is a stock