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  • user warning: Table './mysmp_drupal/cache_filter' is marked as crashed and should be repaired query: UPDATE cache_filter SET data = '<h2>Components of Capital Asset Pricing Model</h2><p>The <b class=\"normalize\">capital asset pricing model</b> (CAPM) is an equilibrium pricing model. The <b class=\"normalize\">CAPM</b> measures how much a given asset\'s return is affected by the movement of the overall market. The <a href=\"/world-markets/sp-500.html\" title=\"S&amp;P 500\">S&amp;P 500</a> is often the benchmark index used in the model. The first component of the CAPM is the beta or risk associated with the asset. Thus, the <a title=\"beta\" href=\"/stocks/beta.html\">beta</a> for a asset is calculated based on the asset\'s returns, Ri, relative to returns from the market, Rm:<br />&nbsp;</p><p><span class=\"inline inline-none\"><img src=\"http://www.mysmp.com/sites/default/files/images/beta.png\" alt=\"\" title=\"\" class=\"image image-_original \" width=\"249\" height=\"240\" /></span></p><p>The second component of the CAPM is the expected rate of return for an asset based on the beta coefficient and the risk free rate of return and the market wide risk premium. The reference point for the risk free rate in the U.S. is the return on a <a title=\"treasury bonds\" href=\"/bonds/treasury-bonds.html\">treasury bond</a>.</p><span class=\"inline inline-none\"><img src=\"http://www.mysmp.com/sites/default/files/images/expected-rate-of-return.png\" alt=\"\" title=\"\" class=\"image image-_original \" width=\"480\" height=\"304\" /></span> <p>For an example let us say that stock A has a beta (Bi = .5%), the risk free rate of return (Rf = 4%) and the expected rate of return for the market (Rm = 10%). You would calculate the expected rate of return for the asset as follows:</p><span class=\"inline inline-none\"><img src=\"http://www.mysmp.com/sites/default/files/images/expected-rate-of-return-example_0.png\" alt=\"\" title=\"\" class=\"image image-_original \" width=\"480\" height=\"304\" /></span> <p>The graphical portrayal of the equilibrium trade-off between expected return and risk is the <a href=\"/video/bonds/security-market-line-sml.html\" title=\"security market line\">Security Market Line (SML). </a>The Capital Asset Pricing Model displays the SML relative to the expected rate of return E(R) and the Beta (B).</p><h2>Example of an Arbitrage Technique utilizing the Capital Asset Pricing Model</h2><p>As you can see in the above model, asset B\'s expected rate of return is greater than the Security Market Line and asset A is sitting on the SML. This is a sign that asset B is currently undervalued and asset A is appropriately priced. So, how can we hedge this position? Assuming that both assets have the same beta and asset B is cheaper than asset A by let\'s say 2%, we can buy asset B and use the proceeds to sell short asset A to hedge our position. This short entry will generate an initial net cash flow because the price of B is less than the price of A. This is inline with the fact that the expected rate of return for asset B is greater than that for asset A. This simple transaction will lock in 2% misevaluation of asset B as a risk less excess return. The excess return is hedged because each asset has the same beta. So, no matter which way the market moves, you have locked in a 2% gain utilizing the capital asset pricing model.</p><p><span class=\"inline inline-none\"><img src=\"http://www.mysmp.com/sites/default/files/images/capital-asset-pricing-model.png\" alt=\"\" title=\"\" class=\"image image-preview \" width=\"515\" height=\"331\" /></span></p><div class=\"image-clear\"></div>', created = 1566528585, expire = 1566614985, headers = '', serialized = 0 WHERE cid = '1:39b0ed3147bf0fc7f1652b3982d25e80' in /var/www/html/mysmp/includes/cache.inc on line 109.
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Arbitrage Capital Asset Pricing Model

Components of Capital Asset Pricing Model

The capital asset pricing model (CAPM) is an equilibrium pricing model. The CAPM measures how much a given asset's return is affected by the movement of the overall market. The S&P 500 is often the benchmark index used in the model. The first component of the CAPM is the beta or risk associated with the asset. Thus, the beta for a asset is calculated based on the asset's returns, Ri, relative to returns from the market, Rm:
 

The second component of the CAPM is the expected rate of return for an asset based on the beta coefficient and the risk free rate of return and the market wide risk premium. The reference point for the risk free rate in the U.S. is the return on a treasury bond.

For an example let us say that stock A has a beta (Bi = .5%), the risk free rate of return (Rf = 4%) and the expected rate of return for the market (Rm = 10%). You would calculate the expected rate of return for the asset as follows:

The graphical portrayal of the equilibrium trade-off between expected return and risk is the Security Market Line (SML). The Capital Asset Pricing Model displays the SML relative to the expected rate of return E(R) and the Beta (B).

Example of an Arbitrage Technique utilizing the Capital Asset Pricing Model

As you can see in the above model, asset B's expected rate of return is greater than the Security Market Line and asset A is sitting on the SML. This is a sign that asset B is currently undervalued and asset A is appropriately priced. So, how can we hedge this position? Assuming that both assets have the same beta and asset B is cheaper than asset A by let's say 2%, we can buy asset B and use the proceeds to sell short asset A to hedge our position. This short entry will generate an initial net cash flow because the price of B is less than the price of A. This is inline with the fact that the expected rate of return for asset B is greater than that for asset A. This simple transaction will lock in 2% misevaluation of asset B as a risk less excess return. The excess return is hedged because each asset has the same beta. So, no matter which way the market moves, you have locked in a 2% gain utilizing the capital asset pricing model.

Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

Tradingsim.com
Day Trading Simulator

Tradingsim.com provides the ability to simulate day trading 24 hours a day from anywhere in the world. TradingSim provides tick by tick data for...

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