Returns are precisely proportionate to risk, which is a fundamental concept of all investing. In other words, the larger the risk, the higher the expected return. The capital asset pricing model (CAPM) is a tool that helps investors figure out what kind of returns they may anticipate based on the degree of risk they’re willing to take.
What Is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) is a mathematical model that captures the link between systematic risk and anticipated return for assets, especially equities. 1 The CAPM is a commonly used mathematical model in finance for pricing hazardous securities and calculating projected returns on assets based on risk and cost of capital.
Understanding the Capital Asset Pricing Model
William Sharpe, an economist and professor, devised the CAPM in the early 1960s. He returned to the topic of risk—specifically, risk that could not be diversified away—and how it effected returns. In his 1970 book, “Portfolio Theory and Capital Markets,” he established the capital asset pricing model based on his research.
Sharpe was interested in diversification, and more precisely, which risks diversification can address which cannot. He recognized two forms of risk in the CAPM framework:
- Systematic risk: This is also known as market risk, and it refers to the overall risk posed by events that affect the whole economy and all financial assets. Interest rates, inflation, recessions, and geopolitical events such as war all have an impact. Systematic risk affects the whole market, which implies that all assets are affected in the same way.
- Unsystematic Risk: These are hazards that are distinct to each asset, often known as specific risk. Individual stocks are vulnerable to negative developments at companies that may not affect any of their peers, for example. Unlike systematic risk, these hazards are not associated across multiple assets.
Diversification, or investing in a basket of diverse assets, helps minimise specific risk—a principle at the foundation of current portfolio theory (MPT). Systematic risk, on the other hand, is a difficult nut to crack since it affects all financial assets in the same manner.
The capital asset pricing model focuses on calculating systematic risk and its effect on asset value. CAPM may be used to determine the fair value of an asset and comprehend the link between risk and projected returns by factoring in systematic hazards.
Key Terms for the Capital Asset Pricing Model
It’s vital to understand the components of the capital asset pricing model before looking at the CAPM equation and how to utilize the result to determine the fair market value of an asset.
- The expected return: The product of the capital asset pricing model. It is a well-founded prediction of the returns an investor may expect over the course of an investment’s lifetime.
- Risk-free rate: The rate of return that an investor would anticipate from a risk-free asset. Because they are backed by the full confidence and credit of the United States government, which has never failed on a payment, Treasury securities are widely used to symbolise the risk-free rate. Depending on an investor’s schedule, several Treasury maturities are employed.
- Beta:In relation to the wider market, this is a measure of volatility. A stock with a beta of 1.0 has the same amount of volatility as the market, which is commonly represented by the returns on the S&P 500, whereas a stock with a beta of less than 1.0 is less volatile than the market. A beta larger than 1.0, on the other hand, suggests that a stock is more volatile than the market.
- A premium for market risk:The additional return required by investors to hold a hazardous market portfolio rather than risk-free assets such as Treasuries, in addition to the risk-free rate. The larger the market risk premium, the more volatile the market or asset class.
What Is the CAPM Formula?
The CAPM formula calculates the expected return on an investment by multiplying the risk-free return by a risk premium.
The risk premium—a higher rate of return than the risk-free rate—represents an investor’s remuneration for taking on systematic risk that can’t be diversified away in the formula.
ER = RFR + [Beta x (MR – RFR)]
- ER:Expected return on a given asset
- RFR:Risk-free rate, or the return on a Treasury security
- MR: Market return, or return on a comparable market index
The risk premium, also known as the market risk premium, is computed in the (MR – RFR) component of the CAPM algorithm.
Market return estimates differ depending on the asset type. An investor can utilise their own market forecasts or historical data from an index, the most popular of which is the S&P 500 for equities.
Why Is the CAPM Important?
In financial modelling and asset appraisal, the CAPM is quite useful. A financial analyst uses the weighted average cost of capital (WACC) to calculate the net present value (NPV) of future cash flows when valuing a company.
The anticipated value computed from the CAPM is used as the cost of equity in the WACC computation. The stock’s fair value is calculated by dividing the company’s worth by the number of outstanding shares.
The current price in relation to fair value is used to make an investment choice. It’s a purchase if the present price is less than the fair value. It’s a sell if the price is more than the fair market value.
Advantages and Disadvantages of the CAPM
The main complaints levelled towards the CAPM revolve with the vagueness of the data used in the calculation.
Take, for example, the risk-free rate. The risk-free rate can change significantly across an analyst’s selected investment time horizon—just look at the yields on treasuries in any unsettled market condition. A higher risk-free rate would raise the cost of capital, while a lower rate would lower it—either scenario would have a major influence on the CAPM calculation’s conclusion.
As a metric of volatility, beta might be problematic. A regression of past stock returns is used to compute beta. Historical stock returns, on the other hand, do not follow a normal distribution. Some observers question whether it is a perfectly accurate indicator of risk because upward and downward price fluctuations are not equally dangerous.
Finally, a theoretical value is used to calculate the market risk premium. The decision of that value is a personal one. Even utilising a historical average from a major index is flawed since no one can predict how the market will perform in the future.
Despite its reliance on a number of assumptions, the CAPM is nevertheless commonly employed. It may play an important role in assisting investment professionals in making educated investment decisions when used in conjunction with other ways of appraising securities.