CAPM

Probably the most famous financial equation to come out of finance. CAPM. With theory, it has reduced a lot of stress and created a lot of happiness for financial professionals. The ability to apply quantitative analysis in business is becoming a real impressive story. CAPM represents the words of capital asset pricing model, not method.

In basic terms, the model provides methodology to quantify risk and translating that risk into estimated expected returns on equity. If you are a client, knowing this reasonable and reliable information might make you very successful. It’s a portrayal of how financial markets price securities, and thereby, figure out expected return on capital investments.

Expected return is a major component of this equation, and simply put, it’s the amount of money you expect to get out of your investment. In most text books, it addresses the issues by providing an interest rate on your investments, let’s arbitrarily say 30%. The expected return of the investment in this equation is calculated by multiplying the market premium by a beta and adding the risk-free rate.

In most studies, the risk-free rate is generally accepted as the rate for treasury bills. You can find it on most federal and governmental websites. The market premium is calculated by taking the expected market return on an investment minus this risk-free rate.

In 2021, the expected stock market return was 26.89%. This number is found on reliable websites or the business website that offers a usual and normal return or rate. The beta, on the other hand, is a little more trickier and seems more mathematical. It is a number from 0-1 that represents how well an individual asset moves to the overall market. This was found to be helpful when multiplying and subtracting generalized stock market numbers. In theory, it sealed the deal for helping to find reliant expected returns. Case in point, a person or company can make better informed decision and choices.

Adding the risk-free rate to the multiplier part of the equation explains the added risk or expected return in addition to secure investments like the old people know are treasury bills. It seems like a basic and original algebraic equation, but it is more mathematical and described in nature as financial. This is due to the fact it uses a lot of data and averaging and simple calculations to configure simple numbers like the risk-free rate, the beta, and expected market’s return. Here’s what the generalized and alphabetized equation looks like:

ER(of investment)=R(risk-free rate) + Beta x [ER(market’s) - R(risk-free rate)]

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“10 Financial Calculations One Should Know for Managing One's Finances.” Business Today, 10 Nov. 2015, https://www.businesstoday.in/magazine/investment/story/top-10-financial-calculations-54363-2015-11-04.