Capital Asset Pricing Model

Part 2, Jan 2, 2021

Lets look at Return equation again

Rs = a + b Rm

We now know the slope of the regression represents the beta of the stock, and measures the riskiness of the stock.

The R squared (R2) of the regression provides an estimate of the proportion of the risk (variance) of a firm that can be attributed to market risk (Rm).

Market risk implies the systematic risk that impacts every stock in the said market. It is the risk inherent to the entire market or market segment and can not be diversified. This affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid.

The balance (1 -­‐ R2) can be attributed to firm specific risk. Firm specific risk represents the risk embedded in the cash flows of the subject firm. Most of the times, we see a company expects its revenue to grow more than the industry growth rate or its EBITDA margin to be higher than what it has achieved in the past or unseen return on the capital employed or more efficient working capital management than its peers have achieved. This risk is diversifiable and is known as unsystematic risk.

This warrants an update to CAPM equation as below:

Return on a stock = risk free rate (Rf) + beta times Equity market risk premium (b * ERP) + firm specific risk premium (alpha)

Rs = Rf + beta * (Rm – Rf) +alpha

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