In the conditions of constant changes in the market, which can sometimes be dramatic, we are faced with a very important question “Where is it right to invest free money at the moment?” You have to find the answer to this question by yourself; we can’t make decisions for you. But we can make your decision easier by introducing you to some basic things
The most well-known one-factor (one-index) model that attempts to establish a connection between systematic risk in the capital market and the rate of return is the Capital Asset Pricing Model (CAPM). The only factor in this model is the market portfolio.
What is a CAPM calculator?
CAPM calculator is a tool used to calculate the CAPM instead of you. Why should you use it? Well, there are a lot of reasons for that. It will provide you with a result in less than a second, which will save you time. With this calculator, you don’t need to write every single number and calculate everything by yourself.
Formula
CAPM = Rf + beta * (Rm – Rf)
Where:
Rf = Risk-free Interest Rate
beta = Market risk of Investment
Rm = Board Market Return
We can provide you with a simple example with the data in the table down below.
| Rf | 2.4% |
| beta | 0.47 |
| Rm | 10% |
CAPM = 2.4 + 0.47 * (10 – 2.4)
CAPM = 2.4 + 0.47 * 7.6
CAPM = 2.4 + 3.572
CAPM = 5.97%
What is CAPM based on?
CAPM is based on these presumptions:
- Capital is effective only when you have well-informed investors.
- Every cost of transactions is ignored.
- Taxation is neglected.
- There is not a large enough investor who could influence the price of financial instruments.
- Existence of risk-free financial instruments that any investor can include in your portfolio.
- Equal expectations of future returns of all investors.
- Existence of one time period in which the yield is expected.
- All financial assets are marketable.
- It is possible to borrow an unlimited amount at a risk-free interest rate.
What affects CAPM?
Beta coefficient
The beta coefficient is the most commonly used when it comes to measuring the systematic component of total risk, and it measures the relative sensitivity of the yield of a particular instrument (or portfolio) to changes in the yield of the market portfolio, for example, measures the relative deviation of the price of securities in relation to a market average.
A market portfolio has a beta equal to 1. Risk-free investments have a beta equal to 0. Securities that have a beta ratio greater than 1 are called offensive securities. If the rate of return of the market portfolio (or market index) increases by one percentage point, the rate of return of the offensive security will increase by more than one percentage point.
However, if the rate of return of the market portfolio decreases by one percentage point, the rate of return of these securities will decrease by more than one percentage point. Therefore, these securities are considered riskier than the average security. For securities with a beta > 1, the rate of return will be higher than the rate of return on the market. Securities that have a beta ratio of less than 1 are called defensive securities. They are considered less risky than the average security.
Risk can be defined as the probability of an adverse event occurring or as the variability of the outcome of an uncertain event. The two basic components of total risk (measured by standard deviation) are a systematic and non-systematic risk.
- Systemic (market) risk is a risk that cannot be reduced by diversification, and its most common measure is the beta coefficient. It affects all types of assets (risk associated with general economic conditions, such as business cycle, inflation rate, interest rates, tax rates, exchange rates, purchasing power, political instability, wars, natural disasters, etc.).
- Unsystematic (specific) risk is a fragment of the summarized risk that is related to a particular company and does not affect other companies (microeconomic impacts or accidental circumstances, such as workers’ strike, failure of the company in research and development, failure to implement important investment projects, litigation, etc.). It can be minimized, even reduced to zero, by using a portfolio diversification strategy
Board market return
The board market return is the ability to perceive a market opportunity that others do not perceive. It can be considered as follows:
Compensation for the function of bearing risk and uncertainty interpretation resulting from the separation of managerial and entrepreneurial functions in joint-stock companies
Although the owners-shareholders have delegated the entrepreneurial function to the managers, they still bear the risk and uncertainty for the capital they have invested in the company. Shareholders who are willing to accept this risk and uncertainty are entitled to compensation, the amount of which should correspond to the degree of risk and uncertainty
Compensation for the company’s ability to offer goods and services that have value to customers.
Board market return arises as a result of the willingness of customers to pay a price that is significantly higher than the cost of production of these goods and services.
Risk-free interest rate
The risk-free interest rate is a rate you get when you cut out all risks, such as credit risk, liquidity, special clauses, tax risk, and premium risk. There are various bonds on the market with different interest rates that depend on the quality of the bonds themselves and their maturity. Since the beginning of the expansion of loans with variable interest rates, many citizens who have borrowed in this way have been able to feel the risks of changes in interest rates. Today, an increasing number of commercial banks offer loans with fixed interest rates, which solve the problem of interest rate risk.
With the increase in the growth rate of retail prices, there is an increase in interest rates and loan principal. A loan indexed by a currency clause is a loan denominated in a certain foreign currency and contains a clause by which the loan repayment is linked to the movement of the exchange rate of that currency. For the users of this type of loan, it carries with it high risks – the risk of changes in the exchange rate (for example, uncertainty for the borrower regarding the total obligation based on the loan, and thus his ability to repay the loan within the agreed period). You can only hedge against this type of risk if your regular monthly net income, from which you repay the loan, is linked to the same currency.