Blog 1 - What is CAPM (Capital Asset Allocation Model)?
I learned about CAPM this week. To understand what it is, I think it's better to use examples.
Suppose you have a friend who has a risk-free return of 3% and he will be willing to choose this opportunity. If your friend chooses to put money into the stock market, the risk of the stock market is greater so the rate of return must be greater than 3% then he will be willing to put money into the stock market. Assuming that the long-term return rate of the stock market is 7% then he is can also accept such a return rate.
One day you want your friends to put your money into your own entrepreneurial project. Obviously, the risk of your personal entrepreneurial project is greater than the risk of listed companies in the market. If you give your friends a return of 3% or 7%. It is obviously unwilling of him to take risk.
So that is the role of CAPM, which has described the issue about "how much investor should expected from your risker business".
E(r), rf and rm is clear, then what is β? β is a way to measure using "volatility" (eg. S&P500) compared to a commonly used system.
β's formula is:
Assume that the trend of the S&P 500 is as shown in Figure 1. Its β is definitely 1. In the same time, assuming that there is a target trend as shown in Figure 2, then we will find that it rises more when the S&P 500 rises, and falls more when the S&P 500 falls. By calculating, the β is 1.9, which means that its volatility is greater than the S&P 500 during the same period. Suppose there is another stock. When the S&P 500 rises, it rises less. When the S&P 500 falls, it falls less. By calculating, the β is 0.6, which means that its volatility is relatively low. This is what β is.
What is the importance of CAPM?
From the Mexican financial crisis in December 1994 to the Thai currency crisis that began on July 2, 1997. The financial crisis in Southeast Asia and the financial turmoil in South Korea and Japan, and the financial crisis in Asia and Russia in 1998. Then in 2008, the global financial turmoil triggered by the US“subprime mortgage crisis”, each financial crisis was accompanied by a sharp drop in asset prices and a sharp increase in transaction execution costs.
In fact, this is largely due to the unreasonable pricing of assets (ie, the deviation of price from value). Therefore, asset pricing research has become a hotspot in the study of financial economics.
Yiran Gu
27/10/2019
Suppose you have a friend who has a risk-free return of 3% and he will be willing to choose this opportunity. If your friend chooses to put money into the stock market, the risk of the stock market is greater so the rate of return must be greater than 3% then he will be willing to put money into the stock market. Assuming that the long-term return rate of the stock market is 7% then he is can also accept such a return rate.
One day you want your friends to put your money into your own entrepreneurial project. Obviously, the risk of your personal entrepreneurial project is greater than the risk of listed companies in the market. If you give your friends a return of 3% or 7%. It is obviously unwilling of him to take risk.
So that is the role of CAPM, which has described the issue about "how much investor should expected from your risker business".
E(r), rf and rm is clear, then what is β? β is a way to measure using "volatility" (eg. S&P500) compared to a commonly used system.
β's formula is:
Assume that the trend of the S&P 500 is as shown in Figure 1. Its β is definitely 1. In the same time, assuming that there is a target trend as shown in Figure 2, then we will find that it rises more when the S&P 500 rises, and falls more when the S&P 500 falls. By calculating, the β is 1.9, which means that its volatility is greater than the S&P 500 during the same period. Suppose there is another stock. When the S&P 500 rises, it rises less. When the S&P 500 falls, it falls less. By calculating, the β is 0.6, which means that its volatility is relatively low. This is what β is.
From the Mexican financial crisis in December 1994 to the Thai currency crisis that began on July 2, 1997. The financial crisis in Southeast Asia and the financial turmoil in South Korea and Japan, and the financial crisis in Asia and Russia in 1998. Then in 2008, the global financial turmoil triggered by the US“subprime mortgage crisis”, each financial crisis was accompanied by a sharp drop in asset prices and a sharp increase in transaction execution costs.
In fact, this is largely due to the unreasonable pricing of assets (ie, the deviation of price from value). Therefore, asset pricing research has become a hotspot in the study of financial economics.
Yiran Gu
27/10/2019
This article is very well written. The author explains what CAPM is, and the author gives an easy example for readers to understand. The author gives the importance of CAPM in the end, which I think is very necessary.
ReplyDeleteThe author provides formula and detailed explanation to help the readers to understand better.
ReplyDeleteThe author explain the formula clearly，and the picture can help me to understand!
ReplyDeleteThis blog explains CAPM clearly and gives an example. There are also many charts about the formula. It looks very comfortably about the interface and includes sense of beauty. I think it will be better if it has the detailed example.
ReplyDeleteThis is a great blog. The author used an example to explain CAPM, using the chart to show the formula, and clearly analyzed the use of CAPM. Obviously, author must a good learner. In the end, I have a question about the limitations of the CAPM. Which situation can not use the CAPM.
ReplyDeleteWhite test can be used to judge CAPM model
DeleteEffectiveness.