CAPM (Capital Asset Pricing Model)

Capital Asset Pricing Model (CAPM)

Overview

The Capital Asset Pricing Model (CAPM) explains the relationship between expected return and risk for a security. It states that the expected return on a security is equal to the risk-free rate plus a risk premium, which compensates investors for taking on additional risk. The risk premium is calculated using the security's beta (β), which measures its sensitivity to market movements.

CAPM Formula

$R_a=R_{rf}+{\beta }_a(R_m-R_{rf})$

where:

• $R_a$​ = Expected return on the security
• $R_{rf}$​ = Risk-free rate
• ${\beta }_a$​ = Beta of the security
• $R_m$​ = Expected return of the market

The formula calculates the expected return by adding the risk-free rate to the product of the security's beta and the market risk premium $(R_m-R_{rf})$.

Components of CAPM

• Expected Return $R_a$: This represents the long-term return an investor expects to earn from a security, considering all variables in the equation.
• Risk-Free Rate $R_{rf}$: This is the return on an investment with zero risk, typically the yield on a 10-year US government bond. The risk-free rate should match the investment's time horizon and the country where the investment is made.
• Beta (β): Beta measures a stock’s risk relative to the overall market. A beta of 1 means the stock moves with the market, greater than 1 indicates higher volatility, and less than 1 indicates lower volatility. A negative beta means the stock moves inversely to the market.
• Market Risk Premium $(R_m-R_{rf})$: This is the additional return over the risk-free rate required to compensate investors for the extra risk of investing in the market. It represents the expected market return minus the risk-free rate.

Assumptions of CAPM

• Risk-Free Asset: Assumes an asset with guaranteed returns exists, allowing unlimited borrowing and lending at the risk-free rate.
• Single-Period Model: Assumes investors have identical, single-period investment horizons.
• Efficient Markets: Assumes markets are perfect and frictionless with no transaction costs or taxes, and all information is available and correctly interpreted by all investors.
• Homogeneous Expectations: All investors have the same expectations about the risk and return of all securities.
• Rational and Risk-Averse Investors: Assumes investors are rational and prefer more wealth to less, choosing higher returns for lower risks.
• Diversified Portfolios: Investors hold diversified portfolios that eliminate unsystematic risk, leaving only systematic risk.
• Only Systematic Risk Matters: CAPM assumes that the only risk priced by the market is systematic risk, measured by beta, as unsystematic risk can be diversified away.
• Unlimited Borrowing and Lending: Assumes investors can borrow and lend unlimited amounts at the risk-free rate.

Importance of CAPM

• Risk-Return Tradeoff Understanding: CAPM provides a quantifiable relationship between expected return and risk, showing that the expected return is a function of the risk-free rate plus a risk premium.

• Portfolio Diversification: CAPM emphasizes the importance of diversification and suggests that only systematic risk is relevant for expected returns, guiding investors to minimize unsystematic risk.

• Security Valuation: Widely used in asset pricing, CAPM helps determine the appropriate discount rate for valuing future cash flows, particularly in stock valuation.

• Performance Evaluation: CAPM helps evaluate the performance of portfolios and individual securities by comparing actual returns to CAPM-expected returns, indicating whether an investment has generated positive or negative alpha.

• Cost of Capital: Businesses use CAPM to estimate their cost of equity, which is crucial for determining their weighted average cost of capital (WACC) and making capital structure decisions.

• Strategic Decision Making: CAPM insights are applied to strategic decisions like expansions, mergers, and acquisitions by understanding the required return for taking on additional risk.

• Regulatory Use: Regulators may use CAPM to set required rates of return for utilities and assess the fairness of returns given risk levels, ensuring companies do not overcharge or take on excessive risk.

• Investment Strategy: Financial advisors use CAPM to tailor investment strategies according to individual risk profiles, helping clients achieve optimal returns for their risk tolerance.

• Educational Framework: CAPM is a foundational model in finance education, introducing students to concepts of systematic risk, the risk-return tradeoff, and market efficiency, forming the backbone of many finance courses.