28 Nov

CAPM – Capital Asset Pricing Model | CA Final SFM

Meaning of β

β is a factor that measure risk associated with any security. It indicates the risk involved in its returns as compared to the risk prevailing in the market. The Beta of the market (base β) is always equal to 1.00. In Question 13, the β of NJ Ltd. share is 1.20 times which indicates 20% additional risk as compared to the risk level prevailing in the market. In other words, if the average market returns decline by 2%, the decline in NJ Ltd.’s share will be by 1.2 X 2 = 2.4%. To conclude, we can say that β factor is the measure of risk involved in returns of a security in relation to the risk involved in the market.

Meaning of Alpha (α)

Alpha is the excess of returns provided by a security over its expected returns as per CAPM. If α of a security is positive then it is beneficial to invest in such security.

Capital Asset Pricing Model (CAPM)

This model is based on the concept that the expected return on a security is aggregate of the risk free rate and the premium for the risk. Consider the data provided in Question 13. The average rate of return prevailing in the market is 20% as against the risk free rate of 10%. Therefore, the excess of returns over the risk free rate will be considered as premium for the risk. Therefore, an investor making an investment in the stock market will expect a return of 10 + 10 = 20% i.e., risk free rate + the reward for risk in the form of premium. However, if the investor makes an investment in equity shares of NJ Ltd., the risk in this security is 20% higher than that prevailing in the market indicated by its β of 1.2 as against the market β of 1.0. Therefore, such investor will expect a premium of 10 x 1.2 = 12% over and above the risk free rate of 10%. Therefore, the expected rate of return as per CAPM for NJ Ltd.’s share will be 22%.

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