Capital Asset Pricing Model (CAPM), In the first three installments, we looked closely at the assumptions that underlie

the Capital Asset Pricing Model (CAPM), as part of our overall project of investigating the role of alpha in hedge fund performance. Today we will review the basic CAPM equations. I promise you wont need a PhD in Mathematics to get the gist. In the single asset case, we use the Security Market Line (SML) that projects the risk/reward characteristics of the asset compared to those of the overall market. The x-axis is beta and the yaxis is return. The slope of the SML is the market risk premium (i.e. the return in excess of the risk-free rate, which is the y-intercept). The slope is given by E(Rm) Rf. The entire SML equation is: (E(R) Rf ) / i = E(Rm) Rf Where E(Ri) is the expected return of asset i Rf is the risk-free rate i , the beta of asset i, the sensitivity of asset return to market return E(Rm) is the expected return of the overall market In other words, the excess return on an asset, deflated by the assets beta, equals the expected return of the market in excess of the risk-free rate. Now, solve for E(Ri) to arrive at the CAPM equation: E(Ri) = Rf + i (E(Rm) Rf) So the expected return on asset i equals the excess return of the market multiplied by the assets beta, added to the risk-free rate. This shows that beta is the sole explanation for an assets expected return. As you know from previous blogs, this is a very shaky assumption. One more rearrangement gives us: E(Ri) Rf = i (E(Rm) Rf) Which shows that the assets risk premium is equal to the market premium multiplied by beta. In other words, the SML is a single-factor model, and beta, which is the assets relative covariance (i.e. covariance / variance) with the market, is that factor. Now you see why we invested three blogs in gauging the real-world verisimilitude of CAPM. In the next blog, well explore how CAPM fares when applied to different hedge fund trading strategies.

Capital Asset Pricing Model (CAPM) Equation in modern portfolio theory expressing the idea that securities in the market are priced so that their expected return will compensate investors for their expected risk. The equation is: r = Rf + (Rm - Rf) x beta where r is the expected return rate on a security; Rf is the rate of a "risk-free" investment, i.e. cash; Rm is the return rate of the appropriate asset class How to Calculate Required Rate of Return February 25 2011| Filed Under Accounting, Business, Economics, Financial Theory, Formulas, Fundamental Analysis, Volatility The required rate of return (RRR) is a component in many of the metrics and calculations used in corporate finance and equity valuation. It goes beyond just identifying the return of the investment, and factors in risk as one of the key considerations to determining potential return. The required rate of return also sets the minimum return an investor should accept, given all other options available and the capital structure of the firm. To calculate the required rate, you must look at factors such as the return of the market as a whole, the rate you could get if you took on no risk (the risk-free rate of return), and the volatility of the stock or the overall cost of funding the project. Here we examine this metric in detail and show you how to use it to calculate the potential returns of your investments.

Risk And Diversification Discounting Models One particularly important use of the required rate of return is in discounting most types of cash flow models and some relative value techniques. Discounting different types of cash flow will use slightly different rates with the same intention - finding the net present value. Common uses of the required rate of return include:

Calculating the present value of dividend income for the purpose of evaluating stock prices Calculating the present value of free cash flow to equity Calculating the present value of operating free cash flow

Equity, debt and corporate expansion decisions are made by placing a value on the periodic cash received and measuring it against the cash paid. The goal is to receive more than what you paid. In corporate finance, the focus is on the cost of funding projects compared to the return; in equities, the focus is on the return given compared to the risk taken on.

Equity and Debt In equities the required rate of return is used in various calculations. For example the dividend discount model uses the RRR to discount the periodic payments and calculate the value of the stock. Finding the required rate of return can be done by using the capital asset pricing model (CAPM). The CAPM will require that you find certain inputs:

the risk free rate (RFR) the stocks beta the expected market return.

Start with an estimate of the risk free rate. You could use the current yield to maturity of a 10 year T-bill - lets say its 4%. Then, take the expected market risk premium for this stock. This can have a wide range of estimates. For example, it could range between 3% to 9%, based on factors such as business risk, liquidity risk, financial risk. Or, you can simply derive it from historical yearly market returns. Lets use 6%, rather than any of the extreme values. Often, the market return will be estimated by a brokerage, and you can just subtract the risk-free rate. (Learn how to calculate the risk premium and why academic studies usually estimate a low. Check out The Equity-Risk Premium: More Risk For Higher Returns and Calculating The Equity Risk Premium.) Last of all, get the beta of the stock. The beta for a stock can be found on most investment websites. To calculate beta manually, use the following regression model: Return of Stock = + stock Rmarket Where:

stock is the beta coefficient for the stock, meaning it is the covariance between the stock and the market divided by the variance of the market. We will assume the beta is 1.25. Rmarket is the return expected from the market. For example, the return of the S&P 500 can be used for all stocks trading on it - and even some stocks not on the index, but related to businesses that are. is a constant that measures excess return for given level of risk (For more on this, see Calculating Beta: Portfolio Math For The Average Investor.)

Now we put together these three numbers using the capital asset pricing model:

E(R) = RFR + stock (Rmarket RFR) E(R) = 0.04 + 1.25 (6) E(R) = 11.5%

Where:

E(R) = the required rate of return, or expected return RFR = the risk free rate stock = beta of the stock Rmarket = return of the market as a whole (Rmarket RFR) = the market risk premium, or the return above the risk-free rate to accommodate additional unsystematic risk

Dividend Discount Approach An investor could also use the dividend discount model, also known as the Gordon growth model. By finding the current stock price, the dividend payment and an estimate of the growth rate for dividends, you can rearrange the formula into: k=(D/S)+g Where:

k = required rate of return D = dividend payment (expected to be paid next year) S = current stock value (if using the cost of newly issued common stock you will need to minus the flotation costs) g = growth rate of the dividend

Definition of 'Dividend Payout Ratio'

The percentage of earnings paid to shareholders in dividends. Calculated as:

Definition of 'Dividend Yield'

A financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock. Dividend yield is calculated as follows:

Dividend discount model The dividend discount model (DDM) is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.[1] In other words, it is used to value stocks based on the net present value of the future dividends. The equation most always used is called the Gordon growth model. It is named after Myron J. Gordon, who originally published it in 1959;[2] although the theoretical underpin was provided by John Burr Williams in his 1938 text "The Theory of Investment Value". The variables are: is the current stock price. is the constant growth rate in perpetuity expected for the dividends. is the constant cost of equity for that company. is the value of the next year's dividends. There is no reason to use a calculation of next year's dividend using the current dividend and the growth rate, when management commonly disclose the future year's dividend and websites post it.

A procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

Swap Fund Swap fund is a mechanism specific to the U.S., first introduced in late 1990s that allows holders of large amount of a single stock to diversify into a basket of other stocks without directly selling their stock. The purpose of this arrangement is to diversify their holdings without triggering a "taxable event". Note that the tax is not avoided, just postponed, when the diversified holdings are eventually sold tax will be due on the difference between the sales price and the original cost basis of the contributed stock

Orderly marketing: Orderly marketing may also refer to coordination of the total supply of a commodity in order to achieve sellers joint market objectives. This is an activity carried out by some marketing order programs

Specialist: The SE facilitates trading through a human being who is known as the specialist. Each stock listed on the SE is allocated to a specialist and all the buying and selling of a stock occurs at the location of this person, known as "the trading post." Buyers and sellers represented by a floor trader will meet at the trading post to learn about the best current bid and ask price for a security. These bid and ask offers are called out loud and indicate the current prices to any interested party. A trade will be executed when the bid and ask orders meet.

The specialist doesn't only match up buyers and sellers. Many specialists are forced to hold an inventory of shares themselves to minimize the imbalance of buy and sell orders. The specialist does this until an equilibrium price is reached, which is when demand and supply are very close. Buying an inventory of stocks is not a common occurrence. In fact, it is estimated that a specialist will be in on only one out of every 10-15 trades.

Another duty that a specialist attends to occurs if a customer's order is priced at a level higher than the lowest ask, or lower than the best bid price (known as a stop order). The specialist will then hold the order and execute it if and when the price of the stock reaches the level specified by the customer.

A final responsibility of the specialist is to find a fair price for each of the stocks that he or she is responsible for at the beginning of every trading day. This fair price is based on the current supply and demand of the stock. The NYSE opens for trading at 9:30am, but if the specialist can't find a fair price, he or she may delay the opening of trading on a stock until that fair price is found. It is the specialist's job to act in a way that benefits the public. Because specialists are responsible for keeping the market in equilibrium, they are required to execute all customer orders ahead of their own. Street Name When you buy securities through a brokerage firm, most firms will automatically put your securities into "street name." This means your brokerage firm will hold your securities in its name or another nominee and not in your name, but your firm will keep records showing you as the real or "beneficial owner." You will not get a certificate, but will receive an account statement from your broker on at least a quarterly and annual basis showing your holdings

The term rationale may refer to:

An explanation of the basis or fundamental reasons for something