CAPM Model & Its uses in the Financial Market

Nowadays, there are number of traders who have shifted from the stock market to the Crypto Currency market; and most of them are looking for the exact calculation of the cost of equity. For such people the accurate tool that is easily available is also positively known as Capital Asset Pricing Model. According to the Capital Asset pricing model, the rate of return on equity will be given by the following relationship:

Cost of equity = the risk free rate + the Beta of the firms share (the market risk premium)

To estimate the 3 parameters firm, cost of equity requires the following equations:

  1. The risk free rate
  2. The market risk premium
  3. The Beta of the firms share

The Risk Free Rate – Whatever yield the Government Treasury Securities offer are primarily used at the risk free rate. One can easily use the return in both ways, through the short term or even through the long term treasury securities.  Normally, most of the time, these short term treasury bills are used as the risk free rates, however, Since most analyst have long term vision, they take long term decisions and usually prefer to utilize the yields on long term government bonds similar to risk free rate. It is been recommended that one should use current risk free rate as compared to historical average.

  1. The Market Risk Premium – The difference between a long term and a risk free rate is known as the market Risk Premium. There are traders and investors who use the market risk premium on the basis of returns received in the recent years. Nevertheless, something that they do not realize is that It is actually not a correct procedure because the possibilities of error in the measurements and short term variability has been higher in recent data. And it is also a reality that the variability of the estimates of a market risk premium will certainly reduce when the market returns of long serious market and risk free rates are used.
  2. The Beta of the firms share – Beta is considered as a systematic risk of the ordinary share in relation to the market. The beta is estimated by regressing the returns of the share to the market share.

Difference between Capital Asset & Dividend Growth Model

One of the main differences between the models is that they approach completely different applications, the dividend growth model only approaches limited applications in practice.

Most of the time these assumptions imply that the dividend growth approach does not apply to those companies that are not paying any dividends, or even to those whose dividend per share is growing at a rate higher than cost of equity. Additionally, it sometimes also does not apply to those companies whose dividend policies are highly volatile.

On the other hand, in the case of Capital Asset Pricing Model, the variables are market determined that expect the company specific share price data’s.  These data’s are also common to all companies of the market. If you are looking forward to gain more information related to CAPM Model then make sure you visit the site