CAPM - The Capital Asset Pricing Model

What Does Capital Asset Pricing Model - CAPM Mean?

In finance, the capital asset pricing model (CAPM) is used to determine a theoretically
appropriate required rate of return of an asset, if that asset is to be added to an already
well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into
account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or
market risk), often represented by the quantity beta (β) in the financial industry, as well
as the expected return of the market and the expected return of a theoretical risk-free
asset.

A model that describes the relationship between risk and expected return and that is used
in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk. The time value of money is represented by the risk-free
(rf) rate in the formula and compensates the investors for placing money in any
investment over a period of time. The other half of the formula represents risk and
calculates the amount of compensation the investor needs for taking on additional risk.
This is calculated by taking a risk measure (beta) that compares the returns of the asset to
the market over a period of time and to the market premium (Rm-rf).

The CAPM is a model for pricing an individual security or a portfolio. For individual
securities, we make use of the security market line (SML) and its relation to expected
return and systematic risk (beta) to show how the market must price individual securities
in relation to their security risk class. The SML enables us to calculate the reward-to-risk
ratio for any security in relation to that of the overall market. Therefore, when the
expected rate of return for any security is deflated by its beta coefficient, the reward-to-
risk ratio for any individual security in the market is equal to the market reward-to-risk
ratio, thus:
The market reward-to-risk ratio is effectively the market risk premium and by
rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing
Model (CAPM).

where:
• is the expected return on the capital asset
• is the risk-free rate of interest such as interest arising from government bonds
• (the beta) is the sensitivity of the expected excess asset returns to the expected

excess market returns, or also ,

• is the expected return of the market
• is sometimes known as the market premium or risk premium (the
difference between the expected market rate of return and the risk-free rate of
return).
Restated, in terms of risk premium, we find that:

which states that the individual risk premium equals the market premium times β.
Note 1: the expected market rate of return is usually estimated by measuring the
Geometric Average of the historical returns on a market portfolio (e.g. S&P 500).
Note 2: the risk free rate of return used for determining the risk premium
"Cap-M" looks at risk and rates of return and compares them to the overall stock market.
If you use CAPM you have to assume that most investors want to avoid risk, (risk
averse), and those who do take risks, expect to be rewarded. It also assumes that
investors are "price takers" who can't influence the price of assets or markets. With
CAPM you assume that there are no transactional costs or taxation and assets and
securities are divisible into small little packets. Had enough with the assumptions yet?
One more. CAPM assumes that investors are not limited in their borrowing and lending
under the risk free rate of interest. By now you likely have a healthy feeling of
skepticism. We'll deal with that below, but first, let's work the CAPM formula.

Beta - Now, you gotta know about Beta. Beta is the overall risk in investing in a large
market, like the New York Stock Exchange. Beta, by definition equals 1.0000. 1 exactly.
Each company also has a beta. You can find a company's beta at the . A company's beta
is that company's risk compared to the risk of the overall market. If the company has a
beta of 3.0, then it is said to be 3 times more risky than the overall market.
Ks = Krf + B ( Km - Krf)
• Ks = The Required Rate of Return, (or just the rate of return).
 • Krf = The Risk Free Rate (the rate of return on a "risk free investment", like U.S.
Government Treasury Bonds - Read our
• B = Beta
• Km = The expected return on the overall stock market.

What rate of return should you get from this company in order to be rewarded for the risk
you are taking? Remember investing in XYZ company (beta =1.7) is more risky than
investing in the overall stock market (beta = 1.0). So you want to get more than 12.5%,
right?
• Ks = Krf + B ( Km - Krf)
• Ks = 5% + 1.7 ( 12.5% - 5%)
• Ks = 5% + 1.7 ( 7.5%)
• Ks = 5% + 12.75%
• Ks = 17.75%
So, if you invest in XYZ Company, you should get at least 17.75% return from your
investment. If you don't think that XYZ Company will produce those kinds of returns for
you, then you would probably consider investing in a different stock.

Investopedia explains Capital Asset Pricing Model - CAPM

The CAPM says that the expected return of a security or a portfolio equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet or beat the
required return, then the investment should not be undertaken. The security market line
plots the results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected
return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk
measure) of the stock is 2 and the expected market return over the period is 10%, the
stock is expected to return 17% (3%+2(10%-3%)).

Assumptions of the Capital Asset Pricing Model

Note! The Capital Asset Pricing Model is a ceteris paribus model. It is only valid within a
special set of assumptions. These are:

• Investors are risk averse individuals who maximize the expected utility of
their end of period wealth. Implication: The model is a one period model.
• Investors have homogenous expectations (beliefs) about asset returns.
Implication: all investors perceive identical opportunity sets. This means
everyone has the same information at the same time.
 • Asset returns are distributed by the normal distribution.
• There exists a risk free asset and investors may borrow or lend unlimited
amounts of this asset at a constant rate: the risk free rate.
• There is a definite number of assets and their quantities are fixated within
the one period world.
• All assets are perfectly divisible and priced in a perfectly competitive
marked. Implication: e.g. human capital is non-existing (it is not divisible and it
can't be owned as an asset).
• Asset markets are frictionless and information is costless and
simultaneously available to all investors. Implication: borrowing rate equals the
lending rate.
• There are no market imperfections such as taxes, regulations, or restrictions on short
selling.

Who introduced the CAPM - Capital Asset Pricing Model?

Harry Markowitz worked on diversification and modern portfolio theory. Jack Treynor,
John Lintner, Jan Mossin and William Sharpe all contributed to the theory of CAPM.
William Sharpe, Harry Markowitz and Merton Miller jointly got a Nobel Prize in
Economics for contributing to financial economics. See, if you study hard and think up
new stuff maybe you can get a Nobel Prize too.

Ah, but CAPM has some flaws.

• If you go to a casino, you basically pay for risk. It's possible that the folks on
Wall Street sometimes have the same mindset as well. Now remember that
CAPM assumes that given "X%" expected return investors will prefer lower risk
(in other words lower variance) to higher risk. And the opposite would be true as
well - given a certain level of risk investors would prefer higher returns to lower
ones. OK, but maybe the Wall Street people get a kick out of "gambling" their
investment. Not saying it's been proven to be the case, just saying it could be.
CAPM doesn't allow for investors who will accept lower returns for higher risk.
• CAPM assumes that asset returns are jointly normally distributed random
variables. But often returns are not normally distributed. So large swings, swings
as big as 3 to 6 standard deviations from the mean, occur in the market more
frequently than you would expect in a normal distribution.
• CAPM assumes that the variance of returns adequately measures risk. This might
be true if returns were distributed normally. However other risk measurements are
probably better for showing investors' preferences. Coherent risk measures comes
to mind.
• With CAPM you assume that all investors have equal access to information and
they all agree about the risk and expected return of the assets. This idea, by the
way is called "homogeneous expectations assumption". Be ready for your
professor to ask, "What's the Homogeneous Expectations Assumption and do you
believe it's valid". Good luck with that one.
• CAPM can't quite explain the variation in stock returns. Back in 1969, Myron
Scholes, Michael Jensen and Fisher Black presented a paper suggesting that low
beta stocks may offer higher returns than the model would predict.
• CAPM kind of skips over taxes and transaction costs. Some of the more complex
versions of CAPM try to take this into consideration.
• CAPM assumes that all assets can be divided infinitely and that those small assets
can be held and transacted.
• Roll's Critique: Back in 1977, Richard Roll offered the idea that using stock
indexes as a proxy for the true market portfolio can lead to CAPM being invalid.
The true market portfolio should include stuff like real estate, human capital,
works of art and so on, basically anything that anyone holds as an investment.
However, the markets for those assets are often non-transparent and
unobservable. So often financial people will use a stock index instead. Does it
kind of seem like they are fudging a little bit. You might argue they are.
• CAPM assumes that individual investors have no preference for markets or assets
other than their risk-return profile. But is that really the case? Say a guy loves
drinking Coke. Only Coke. He's collects old Coke bottles and stuff. OK, now, is
that guy going to buy stock in Pepsi based only on its risk-return profile, or is he
going to buy stock in Coke so he can brag to everyone about how many shares he
has?
•
Security market line
The SML essentially graphs the results from the capital asset pricing model (CAPM)
formula. The x-axis represents the risk (beta), and the y-axis represents the expected
return. The market risk premium is determined from the slope of the SML.

The relationship between β and required return is plotted on the securities market line
(SML) which shows expected return as a function of β. The intercept is the nominal risk-
free rate available for the market, while the slope is the market premium, E(Rm)− Rf. The
securities market line can be regarded as representing a single-factor model of the asset
price, where Beta is exposure to changes in value of the Market. The equation of the
SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a

reasonable expected return for risk. Individual securities are plotted on the SML graph. If
the security's expected return versus risk is plotted above the SML, it is undervalued
since the investor can expect a greater return for the inherent risk. And a security plotted
below the SML is overvalued since the investor would be accepting less return for the
amount of risk assumed.