What is an Asset Pricing Model?

The asset pricing model or capital asset pricing model(CAPM) is a means of assessing the systematic risk of investing in a stock and determining the expected rate of return. Nobel prize-winning economist William Sharpe first proposed CAPM in 1970. The appropriate return for a stock is estimated by using the asset's beta risk, which is a measure of the relative volatility of the stock compared to the market. CAPM centers on the assumption that increased risks warrant and should produce higher returns. By using the capital asset pricing model, an investor can ascertain whether the current stock price is consistent with its predicted rate of return.

Assets with betas of zero are relatively free of risk. The formula used by the asset pricing model opens with the risk-free rate of return, for example, the rate of a ten-year Treasury bond. Written out, the formula is as follows: Expected Return = Risk-free rate + Beta (Market Rate - Risk-free rate). Subtracting the risk-free rate from the median market return provides the extra amount an investor should get when investing in the stock market above that of a risk-free asset. In order to generate an estimate of a reasonable, expected rate of return, the premium is subsequently multiplied by the beta of the individual stock and added to the risk-free rate.

For example, if a ten-year Treasury bond yields two percent, then the risk-free rate is two percent. If the market rate is 10 percent, then the premium generated by stock investment is eight percent, derived by subtracting the risk-free two percent from the market rate. Company XYZ has a beta risk of two. The premium that investment in Company XYZ should produce over the risk-free rate is calculated by multiplying two times eight. Company XYZ stock should generate a 16 percent bonus over the risk-free rate of two percent, or 18 percent.

The security market line (SML) is a line graph of the asset pricing model system, with beta plotted on the horizontal axis and asset return on the vertical axis. With an upward slope to the right, the line represents the relationship between beta and expected return. If investors compare the actual returns of a company on this plot, stocks yielding returns that plot below the line are poor performers, with the return not justifying the risk. On the other hand, if the actual return plots above the line, the stock is undervalued. This stock is a bargain.