What is Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.Below is an illustration of the CAPM concept.
What Does CAPM Mean?
This model assumes that there are many investors with the same investment horizon and equal access to information and securities. All investors share homogenous beliefs about the investment opportunities offered in the market and are all price takers. They all borrow at a risk-free rate and pay no taxes or commissions.
This model helps these investors calculate the risk on their investments and what type of return they should expect to get based on the level of risk involved with the investment.
Why is CAPM Important to Understand in Investing?
The CAPM gives investors a simple calculation that they can use to get a rough estimate of the return that they might expect from an investment versus the risk of the outlay of capital. The capital asset pricing model helps you to understand the importance of diversification. Investors who follow the CAPM model choose assets that fall on the capital market line by lending or borrowing at the risk-free rate.
Diversification is the act of including different kinds of asset classes in a portfolio. Diversification of the assets in your portfolio can help you to hedge against its risk.
The (capital asset pricing model) CAPM formula is represented as below
Expected Rate of Return = Risk-Free Premium + Beta * (Market Risk Premium) Ra = Rrf + βa * (Rm – Rrf)
The CAPM calculation works on the existence of the following elements
#1 – Risk-free return (Rrf)
Risk-Free Rate of Return is the value assigned to an investment that guarantees a return with zero risks. Investments in US securities are considered to have zero risks since there is a minimal chance of the government defaulting. Generally, the value of the risk-free return is equivalent to the yield on a 10-year US government bond.
#2 – Market Risk Premium (Rm – Rrf)
Market Risk Premium is the expected return an investor receives (or expects to receive in the future) from holding a risk-laden portfolio instead of risk-free assets. The premium rate allows the investor to make a decision on if the investment in the securities should take place, and if yes, the rate that he will earn beyond the risk-free return offered by government securities.
#3 – Beta (βa)
The Beta is a measure of the volatility of a stock with respect to the market in general. The fluctuations that will be caused in the stock due to a change in market conditions is denoted by Beta. For example, if the Beta of a stock is 1.2, it would cause a 120% change due to any change in the general market. The opposite is the case for Beta less than 1. For Beta, which is equal to 1, the stock is in sync with the changes in the market.
Beta/Market Sensitivity Relationship:
- β = 0: No Market Sensitivity
- β < 1: Low Market Sensitivity
- β = 1: Same as Market (Neutral)
- β > 1: High Market Sensitivity
- β < 0: Negative Market Sensitivity
What are the advantages and disadvantages of CAPM for investors?
Below are some benefits of this risk-reward model for investors.
- Assumption that your portfolio is diverse
This model assumes an investor has a diverse investment portfolio that can reduce specific or unsystematic risk.
- Simple and convenient
The model’s simplicity is its foundation. These calculations are reliable and allow investors to make informed decisions when choosing equities.
- This calculation can be significantly altered by systemic risks
The beta factor in capital asset pricing models considers all systematic risks that are associated with an investment. The effects of these risks on returns is ignored by the dividend discount model (or DDM), which is another popular return prediction model. Market risk is unpredictable and unpredicted, so investors cannot completely mitigate it.
Problems With the CAPM
There are several assumptions behind the CAPM formula that have been shown not to hold in reality. Modern financial theory rests on two assumptions: (1) securities markets are very competitive and efficient (that is, relevant information about the companies is quickly and universally distributed and absorbed); (2) these markets are dominated by rational, risk-averse investors, who seek to maximize satisfaction from returns on their investments.
Despite these issues, the CAPM formula is still widely used because it is simple and allows for easy comparisons of investment alternatives.
Including beta in the formula assumes that risk can be measured by a stock’s price volatility. However, price movements in both directions are not equally risky. The look-back period to determine a stock’s volatility is not standard because stock returns (and risk) are not normally distributed.
The CAPM also assumes that the risk-free rate will remain constant over the discounting period. Assume in the previous example that the interest rate on U.S. Treasury bonds rose to 5% or 6% during the 10-year holding period. An increase in the risk-free rate also increases the cost of the capital used in the investment and could make the stock look overvalued.
The market portfolio that is used to find the market risk premium is only a theoretical value and is not an asset that can be purchased or invested in as an alternative to the stock. Most of the time, investors will use a major stock index, like the S&P 500, to substitute for the market, which is an imperfect comparison.
The most serious critique of the CAPM is the assumption that future cash flows can be estimated for the discounting process. If an investor could estimate the future return of a stock with a high level of accuracy, the CAPM would not be necessary.
Advantages of CAPM
- CAPM takes into account only the systematic or market risk or not the security’s only inherent or systemic risk. This factor eliminates the vagueness associated with an individual security’s risk, and only the general market risk, which has a degree of certainty, becomes the primary factor. The model assumes that the investor holds a diversified portfolio, and hence the unsystematic risk is eliminated between the stock holdings.
- It is widely used in the finance industry for calculating the cost of equity and ultimately for calculating the weighted average cost of capital, which is used extensively to check the cost of financing from various sources. It is seen as a much better model to calculate the cost of equity than the other present models like the Dividend growth model (DGM)
- It is a universal and easy to use model. Given the extensive presence of this model, this can easily be utilized for comparisons between stocks of various countries.
Disadvantages of CAPM
- The capital asset pricing model is hinged on various assumptions. One of the assumptions is that a riskier asset will yield a higher return. Next, the historical data is used to calculate Beta. The model also assumes that past performance is a good measure of the future results of a stock’s functioning. However, that is far from the truth.
- The model also assumes that the risk-free return will remain constant over the course of the stock investment. If the return on the government treasury securities rises or falls, it will change the risk-free return and potentially the calculation of the model. It is not taken into account while calculating the CAPM
- The model assumes that the investors have access to the same information and have the same decision-making process with respect to the risks and returns associated with the securities. It assumes that for a given return, the investors will prefer low-risk securities to high-risk securities. For a given risk, the investors will prefer higher returns to lower returns. Although this is a general guideline, some of the more extravagant investors might not be in agreement with this theory.
Limitations of the Capital Asset Pricing Model
Apart from the assumptions directly related to the factors around the stock and the capital asset pricing model calculation formula, there is a list of general assumptions that the model takes, which are worth looking into.
- Only the returns and risks involved in the securities are the decision making factors for an investor. There is no accountability of the long term growth or qualitative factors around a stock that could influence the investor to take an alternative step.
- There is perfect competition in the market, and no single investor can influence the prices or the returns of a stock. There is no limit on the short-selling of a stock; neither is their control on the divisibility of the purchase and selling units.
- There are nil taxes with regards to the returns earned or any borrowing costs with respect to the amount that is additionally utilized to earn interest on the investment.
- Finally, the model assumes that the investor is risk-averse, and he is supposed to act as a rational being and maximize his utility.
The Capital Asset Pricing Model (CAPM) can be used to calculate the rate of return that should be expected from an asset to compensate for the investment risk that the investor took with investing in the market. It could be said that it is the economic lifeline when taking the investment risk in which they expect greater profitability from their finances. CAPM is one of the most important contributions in the financial sector of companies that is subject to the changing systematic risk factors of the market.
This model makes it possible to estimate the required return as the expected return on a financial asset such as a company’s ordinary shares. The rational investor then seeks to maximize his return while at the same time decreasing the systematic risk of his investment and with this maintain and buy the shares of a company.
Today the CAPM model is still popularly used by investors since it is a simple model to enter the field of finance that facilitates managing the results of high investment risks in the markets in which you want to participate.