An investor should always know where she is investing.
She should always compare the risk she is gonna take to the return she is expecting.
Higher the risk, higher should be the return.
But is there any way to get the idea of how much return we should expect for any particular
investment?
One of the best way to calculated expected return from an investment is CAPM, which is
Capital Asset Pricing Model.
Lets first take a look at the formula and then try to understand it.
Expected return equals to risk free return, plus beta, times market return, minus risk
free return.
The first part of formula is risk free return which means the return on investment when
there is no risk.
Generally, it is considered interest rate of government bonds.
Since government doesn't default in their payments, their bonds are considered risk
free.
Second part of formula calculate the premium an investor should earn, because of the risk
she is going to take by investing in the security.
Now, lets understand each component of second part.
what is market return?
It is generally considered future one year return of a benchmark.
In case of equity, the benchmark could be any major equity index like BSE Sensex, or
BSE 100, or BSE 500.
Future returns can be ascertained based on different parameters, like past returns, micro
and macro economics, government policies, etc.
Risk free return will be the same as shown before, i.e. interest rate of government bonds.
The difference between these two will be multiplied by beta.
Now, what is beta?
In simple terms, beta indicates risk.
Farther the beta from zero, higher the risk. and it applies to both sides of zero; positive
and negative.
Zero beta, means stock has got no correlation with its benchmark.
One beta indicates it is perfectly correlated with its benchmark.
More than one means stock is more volatile than its benchmark.
For example, A beta of 1.5 means if benchmark increases by 2%, then stock will increase
by 3%; i.e. 2 multiply by 1.5.
And lastly, negative beta means stock and it's benchmark is negatively correlated, i.e. if benchmark
increases, stock decreases, and vice versa.
Lets take an example, suppose Mrs. Sharma wants to invest in shares of ABC Ltd., whose
beta is 2.2.
Current rate of interest on government bond is 8%, and future market return is expected
to be 9.5%.
So how much return Mrs. Sharma can expect?
Now, lets put the values in the formula to get the result.
8%, plus 2.2, multiply by 9.5%, minus 8%.
By solving the equation, the answer we get is 11.3%.
Mrs. Sharma can expect around 11.3% return for a year, excluding transactional cost.
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