The Capital Asset Pricing Model is a popular asset pricing model in Finance. It is used to determine the expected rate of return of a risky asset. It says that the expected return on a risky asset is equal to the risk-free rate plus a risk premium. The risk premium is a measure of non-diversifiable […]

# CAPM and Multi-factor Models

## How to Calculate Stock Beta in Excel

Beta (β) measures the volatility of a stock in relation to a market such as S&P 500 or any other index. It is an important measure to gauge the risk of a security. The market itself is considered to have a Beta of 1. Using regression analysis, the beta of the stock is calculated. If […]

## Securities Market Line (SML)

The securities Market Line (SML) is a graphical representation of the Capital Asset Pricing Model (CAPM). Essentially, it displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta). Assume that the historical market return is 12%, and the risk-free rate is 5%. The expected return of […]

## Sharpe Ratio for Measuring Return on Risk

While deciding on about what investments to make, one should weigh the rewards versus the risks of the investment opportunity. The Sharpe ratio is one popular measure of return on risk. It is named after Nobel Laureate professor William F. Sharpe. The Sharpe ratio measures the reward (or excess return) of an asset per unit […]

## Sharpe Ratio as Performance Benchmark

In a business context, Sharpe ratios can be used for: Setting targets for results Evaluating performance after the fact Benchmarking Sharpe Ratio is a standard benchmark Sharpe ratios are easy to calculate and can be used to compare the performance of a variety of different asset classes, or businesses. For budgeting and planning purposes, we […]

## Jensen’s Alpha

Jensen’s Alpha, also known as the Jensen’s Performance Index, is a measure of the excess returns earned by the portfolio compared to returns suggested by the CAPM model. It represents by the symbol α. The value of the excess return may be positive, negative, or zero. The CAPM model itself provides risk-adjusted returns, i.e., it […]

## Single Index Model

The Single Index Model (SIM) is an asset pricing model, according to which the returns on a security can be represented as a linear relationship with any economic variable relevant to the security. In case of stocks, this single factor is the market return. The SIM for stock returns can be represented as follows: Where: […]

## Systematic and Specific Risk

The risk arising from the volatility in the stock prices is referred to as Equity Price Risk. While talking about price volatility, it is important to differentiate between systematic risk and unsystematic risk. Systematic risk refers to the risk due to general market factors and affects the entire industry. It cannot be diversified away. Unsystematic […]

## Arbitrage Pricing Theory (APT)

We had seen earlier that CAPM, which is essentially a Single Index Model, considers that the returns of a stock are affected only by a single factor, which is the excess market returns. The Arbitrage Pricing Theory takes a more complex approach and allows the returns of a stock to be influenced by multiple factors. […]