Page 151 - A Canuck's Guide to Financial Literacy 2020

151

Example of CAPM Formula

Below we’re going to calculate the expected return of Company A given the following
information. The risk-free rate in the market is currently 5% and the market return is 10%. If
Company A has a stock beta of 1.5, what would be it’s expected return?

12.5% = 5% + 1.5 ∗ (10% − 5%)

The expected return on company A would be 12.5%

Limitations with CAPM

CAPM has often been criticized due to the fact that it’s based on assumptions. The formula
states that a riskier asset will generate higher return but this is not always the case. A riskier
asset could also generate lower returns. In addition, CAPM uses historical data to predict
expected future results. Past returns are not indicative of future returns and historical
volatility may not reflect the future. Another point of criticism is that CAPM does not account
for changes in the risk-free rate. It assumes that the rate will remain constant over time.