CAPM Capital Asset Pricing Model in 4 Easy Steps - What is Capital Asset Pricing Model
Explained
Hello I’m back and welcome once again to another easy lesson or review or tutorial
by MBAbullshit.com.
So, today or this time our topic will be on or about CAPM or the Capital Asset Pricing
Model in the field of finance or Financial Management.
Management sounds scary or complicated but don’t worry this is just MBAbullshit.
And we can cut through the bullshit and you can see how easy and simple it actually is.
Okay, just remember you can always come here whether you’re a business student, college
BBA or MBA or if you’re an executive who just wants to learn because you don’t have
time for MBA or because you need refresher from your previous MBA or if you’re a non
business moron like me before and maybe an artist, or a creative person or a doctor and
you just want to learn the concepts of MBA quickly and easily.
You can always go to MBAbullshit.com for lots of free video.
Okay?
So now, let’s go to the Capital Asset Pricing Model.
Now, most professors will explain the Capital Asset Pricing Model or CAPM as a formula which
looks like this: Ke = Rf + B (Rm-Rf).
Now, I know this formula over here can look scary and intimidating but please do not panic
because this is actually very simple when I show you step by step how easy it actually
is.
So, don’t worry about it but in order to allow you to understand it well, I want you
to first remove this first complicated bull shit from your brain right now temporarily.
We’ll get back to it later.
Remove it from your brain, don’t panic and I just want you to focus on this other thing
I’m going to show you now.
Okay?
You’re going to see, it’s not complicated at all.
So, I’m going to start by telling you a story and in the story I’m going to give
you a choice.
Let’s say, I offered you a risk free investment.
Okay?
It was an investment or it’s an opportunity for you to earn money by putting your money
in my bank.
You have a deposit account in my bank and my bank is guaranteed by the government and
so therefore it is risk free, zero risk and for sure the bank will not collapse like what
happened in the recent economic crisis.
In this case you’re 100% sure that the bank would not collapse.
And you have the opportunity, you have the offer to deposit your money in this bank and
the bank will give you an interest of 2%.
So the 2% here is what we called the risk free rate.
So let’s just say that you can put your money in my bank, my bank has no risk and
you can earn 2% interest or 2% income or 2% profit on your money by depositing that money
with this bank.
And then I give you a second choice with an investment which has medium risk.
And for this example, let’s just use or let’s just say that the United States stock
market, the general stock market has medium risk.
So bank here, the bank deposit has no risk or zero risk and the US general stock market
has medium risk which is also called systematic risk.
Now, don’t worry so much about the systematic risk here.
This is just MBAbullshit and for now let’s just use the word medium risk and we can get
back to the systematic risk later.
It’s called systematic risk because it represents the risk of a certain system which is usually
used such as the United States stock market.
But if you don’t understand what I just said don’t worry about it, just forget it
for now.
For now let’s just say it’s medium risk.
Now, what if I also offered you a risk free investment, zero risk investment or deposit
earning 2% and I also offered you a medium risk investment?
And this medium risk investment would earn you also 2%.
It would also earn you 2%.
So if you had to choose between this investment here or this investment here, which one would
you choose?
Which one?
They earn the same amount but this one has higher risk than this.
Well if you have at least some intelligence then for sure you would choose this investment
and not this one.
Why?
Because in this investment you earn 2% but you have no risk.
In this investment you also earn the same small profit of 2% or you expect to earn the
same small profit of 2% but you have even higher risk compare to this one over here.
So of course it makes much better sense to put your money here in the no risk investment.
Let me ask you; let’s say I was a stock broker who trades stocks in the United States
and I want to convince you to move your money away from here and instead put your money
here.
How would I do that if I’m only giving give you 2%?
Well, of course the normal way would be for me to try an offer you more than 2% and I’d
tried to offer you extra money, extra profit or extra percentage here.
That way it would be worth it for you to move your money from here to here because now you’re
earning more profit in order to pay you for the extra risk.
For this example, let’s just say I’d offer you an extra 6% return or extra 6% profit
on your money to place your money here instead of here.
So now, these two investments have equal attractiveness, let’s just called it equal attractiveness
because here you only earn 2% but you’ve got no risk, here you earn 2% plus 6% but
you have medium risk and medium risk is more than no risk.
So now, these 2 choices should have equal attractiveness.
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