Collaborative Review Task M1

CAPM Model

1. Write the CAPM the equation, specifying what each term means.

CAPM equation for given equity is given by:

ER = Rf + β*(ERm-Rf)

Where,

ER – Expected Return of stock

Rf – Risk-free return

β – Beta of the investment

ERm – Expected return of a market

2. Explain in words how the model explains the return of a stock.

Investors expect to be compensated for risk and the time value of money. The risk-free rate in the
CAPM formula accounts for the time value of money i.e. if the investor’s money is invested in a
risk-free deposit, it can be expected to grow at this rate. The other components of the CAPM
formula account for the investor taking on additional risk.
Defining Beta
The beta of a potential investment is a measure of how much risk the investment will add to a
portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater
than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a
portfolio. Beta is the measure of the systemic risk or volatility of the investment as compared to
the market. It measured as the covariance of stock return with the benchmark (market) return
divided by the variance of the market returns.
A stock’s beta is then multiplied by the market risk premium, which is the return expected from
the market above the risk-free rate. The risk-free rate is then added to the product of the stock’s
beta and the market risk premium. The result should give an investor the required return or
discount rate they can use to find the value of an asset.

3. Choose a stock. Download 1 year worth of data of the adjusted closing price.
Downloaded MSFT stock prices from 15-Jun’21 to 14’Jun’21.
Read command on R: msft<-read.csv(“MSFT.csv”)

4. Compute the return from this series.

R command : n<-length(msft$Adj.Close)
msft$lret <- c(NA, log(msft$Adj.Close[-1]/msft$Adj.Close[-n]))
 5. Find the stock’s beta from a financial website. 
Microsoft’s Beta 1Y, Daily=1.28
6. Choose a benchmark, say the SP500. Download 1 year worth of data of the adjusted
closing price. Make sure the time period matches for the benchmark and the stock.
Selected SP500 index as the benchmark.
Read command : spx<-read.csv(“bench.csv”)

7. Compute the return of this benchmark.

R Command : n<-length(spx$Adjclose)
spx$Adjclose <- c(NA, log(spx$Adjclose[-1]/spx$Adjclose[-n])

8. Formulate the CAPM using your stock’s return, the benchmark return, and a risk-free
rate
US Rick Free Rate = 1.47%
MSFT 1Y, Daily Beta:
msftData <- merge(msft, spx, by=’Date’)
beta<-cov(msftData$lret.x, msftData$lret.y)/var(msftData$lret.y)
which comes out to be ~1.288406
Expected Return for MSFT using CAPM:
1.47 + 1.288*(-0.209-1.47) = -0.422%