Expected Return: This is the return that an individual expects a security to earn over the next period. This is only an expectation and the actual return may be higher or lower. An individual’s expectation may simply be the average return per period a security has earned in the past. Alternatively, it may be based on a detailed analysis of a firm’s prospects, on some computer-based model, or on inside information. Capital Asset Pricing Model: The Capital Asset Pricing Model (CAPM) measures the risk premium for a capital investment by comparing the expected return on that investment with the expected return on the entire securities market.
In other words, the expected return on the market is the sum of the risk-free rate plus some compensation for the risk inherent in the market portfolio. The CAPM summarizes this relationship by the following equation. In words, the expected return on the market is the sum of the risk-free rate plus some compensation for the risk inherent in the market portfolio. The above equation refers to the expected return on the market, not the actual return in a particular month or year.
As securities have risk, the actual return on the market over a particular period can be below Rf, or can even be negative. Since investors want compensation for risk, the risk premium is presumed to be positive. It is generally argued that the best estimate for the risk premium in the future is the average risk premium in the past. The average annual risk free return over the past 3 years has been close to 3 percent and the average annual return of the market has been close to 12 percent. Thus, the average difference between the two is 9 percent, which is the risk premium.
Step 2 – Calculation of the Expected Return on Individual Security We believe that the beta of a security is the appropriate measure of risk in a large, diversified portfolio and the expected return on a security should be positively related to its beta. There are two ways to determine the beta of a stock. The first one is by using the formula mentioned below:. We can also estimate beta by running a linear regression of the return on the securities against the excess return on the market (Rm – Rf).
In practice, running a regression involves gathering a number of observations of return on the security over a period together with observations for the same period on a variable that somehow captures the market-wide factors. We assume that return on the market portfolio epitomizes the impact of market-wide factors. Therefore, for every observation that we have for the security, we shall also gather information on the return on the market portfolio for the same period.