Thursday, January 9, 2014

What is CAPM?

CAPM or the Capital Asset Pricing Model is something I would expect you to define rather than calculate on your Series 65 or Series 66 exam. But, the exam will throw out a few tough calculations, so let's figure out the expected return of KKD common stock based on CAPM, just in case. CAPM uses just three numbers: risk-free rate, beta, expected market return. Why does it do that? Because the idea behind CAPM is that investors expect to be compensated not just for the risk they're taking but for the time value of money, too. Therefore, the expected return is just a function of assuming that the investment will receive the riskless rate of return plus a "risk premium." That risk premium is basically just a function of the expected market return and the beta of the stock. So, KKD has a beta of 2. The expected market return is 9%. The rate on 3-month T-bills is 1%. Let's plug in those numbers:


Usually we see that in parentheses, but the strange "formula" above shows the order of the operations. Take 1% and hold that thought. Take two times nine (18) minus two times one (2) to get 16. Add 1 plus 16, and Krispy Kreme (KKD) common stock has an expected return of 17%. Pass your exam!