- Alright, we've introduced all the pieces.
We are now ready to look at the entire
capital asset pricing model.
Remember, the risk-free rate is the minimum return
that we have to earn on any investment.
Returns on investments in the stocks of companies
have to be higher than the risk-free rate.
We call that difference the equity-risk premium.
Alright, so how much higher?
Well that depends on the risk associated
with the investment, and remember
that this is unavoidable risk, or beta risk.
Some risk can be avoided through diversification,
but the beta risk cannot be avoided through diversification
because it relates the overall movements
in the economy.
Let's see how the capital asset pricing model
works with some numbers.
Let's use Ford Motor Company to start.
Remember, if you want to induce me to invest
in Ford Motor Company, you have to at least
make me think that I'm going to earn
the risk-free rate of 5%.
In addition there needs to be an equity risk premium,
we'll start with the standard equity risk premium
of 6%, but Ford Motor Company, as we recall
has a high beta because Ford Motor Company
is very susceptible to economy-wide movements.
1.8 is the beta for Ford Motor Company,
so the total equity risk premium
is the standard risk premium, 6% multiplied by 1.8,
which is 10.8%.
If you want me to invest in Ford Motor Company,
you need to convince me that the investment
is going to earn at least the risk-free rate of 5%,
plus another 10.8% equity risk premium, 15.8% all together.
If I don't think I can earn 15.8% in an investment
in Ford Motor Company, I'm not going to make the investment.
That's the insight from the capital asset pricing model.
How 'about Walmart?
Walmart has low beta risk.
Walmart's economic circumstances are almost
independent of overall economic movements,
so the company has low beta risk.
If you want me to invest in Walmart,
I have to first expect a risk-free return of 5%,
then the equity risk premium is going to be quite low.
The equity risk premium is the standard amount of 6%,
multiplied by Walmart's 0.36 beta,
so I only need to expect an equity risk premium
with respect to Walmart of 2.2%,
5% risk-free rate plus 2.2% equity risk premium
gives a total required return for an investment
in Walmart stock of 7.2%.
Now you might think that these computations
seem pretty simple, and that nobody would
actually use this.
Well I was in a court room for two weeks
a few years ago, we sat there for two weeks
arguing about a court case involving tens
of millions of dollars, and we spent the entire time
arguing about which numbers to plug
into the capital asset pricing model.
According to the capital asset pricing model,
the return that a person must expect
in order to get her or him to make an investment
is the risk-free rate plus an equity risk premium,
which is based on the beta.
Now that you know the capital asset pricing model,
the CAPM, try it out on your friends
the next time you go to a party.