Use CARMa to Price Your Stock: Equity Risk Premiums Reinvented with Exchange-Traded Funds

Abstract

CARMa (constant adaptation to real markets) is an equity risk premium framework designed to help investors value stocks given real-world conditions. It measures risks that investors are likely to encounter by owning a specific stock, such as shifting consumer preferences, evolving investor psychology, or potential illiquidity. The need for CARMa centers around the fact that the techniques most commonly used by practitioners today (i.e., capital asset pricing model–based) work well when stock-specific risk doesn’t change much but struggle when it does. CARMa is designed to measure a stock’s intrinsic value in the context of its future risk and evolve as its risk profile does. The fundamental difference between CARMa and convention centers on linkage. Convention is built on the concept that stock-specific risk is linked to the overall market, and this relationship is predetermined (via beta). In the CARMa approach, stock-specific and systematic risks are measured independently; there is no predetermined connection. As such, CARMa can evolve in tandem with changes in the stock’s particular risk profile.