Reading: Capital Asset Pricing Model (CAPM)

The module started out by arguing that we need to know three factors to determine the risk-adjusted discount rate of an asset (project):

• The risk-free rate of return
• A measure of the riskiness of the project
• A measure for the price of risk, i.e., the return spread we can expect to earn per "unit" of risk.

To determine the appropriate discount rate, we have combined the three elements as follows:

Discount rate = Risk-free Rate + Amount of Risk × Price of Risk.

In words: The minimum return that the investors expect to earn is the risk-free rate of return. If the project in question is not risk free, the investor expect to earn a risk premium on top of the risk-free rate. To measure this risk premium, it makes sense to decompose it into two parts: the amount of risk and the price of risk.

The purpose of this section is to show how the knowledge from the preceding sections on portfolio theory can help us complete our search for the appropriate discount rate. The section proceeds as follows:

• The next section presents the theoretical framework to estimate discount rates. This framework is summarized in the Capital Asset Pricing Model (CAPM), which is the practically most relevant model to estimate discount rates.
   
  
• Next, we present a few examples to practice the crucial steps in the implementation of the CAPM.
   
• We conclude with a summary of the model and a discussion of the most important takeaways.